BUILDING THE FOUNDATIONS FOR FINANCIAL SECTOR DEVELOPMENT IN MONGOLIA nt me lop Deve ings Sav Fin an ce t men est Inv December 2024 BUILDING THE FOUNDATIONS FOR FINANCIAL SECTOR DEVELOPMENT IN MONGOLIA December 2024 World Bank with external contributions. The findings, interpretations, and conclusions expressed in this report do not necessarily reflect the views of the World Bank, the Executive Directors of the World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this report. Rights and Permissions The material in this publication is copyrighted. Copying and/or transmitting portions or all of this work without permission may be a violation of applicable law. The International Bank for Reconstruction and Development/ The World Bank encourages dissemination of its work and will normally grant permission to reproduce portions of the work promptly. For permission to photocopy or reprint any part of this work, please send a request with complete information to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, USA, telephone 978-750-8400, fax 978-750-4470, http://copyright.com/. All other queries on rights and licenses, including subsidiary rights, should be addressed to the Office of the Publisher, The World Bank, 1818 H Street NW, Washington, DC 20433, USA, fax 202-522- 2422, email pubrights@worldbank.org. CONTENTS 01 Executive Summary 7 02 Context 13 03 Strengthening central bank independence, governance and oversight 28 04 Tackling distortions and risk factors 34 05 Fostering market development 38 06 Strengthening credit market infrastructure 46 Annex 51 Building the foundations for financial sector development in Mongolia Tables and Figures Figure 1. Macroeconomic developments 14 Figure 2. Trade partners and main products 15 Figure 3. Financing gap and source of funding 16 Figure 4. Financial sector developments 19 Figure 5. Banking sector balance sheet structure 21 Figure 6. Financial sector concentration 23 Figure 7. Financial sector asset quality 25 Figure 8. Central bank bills, debt capital market and the government 27 Figures Figure 9. Current structure of the foreign exchange market 34 Figure 10. Envisaged future structure of the foreign exchange market 35 Figure 11. Subsidy schemes impact on bank lending (billion MNT, %) 36 Figure 12. Chronology of the subsidy schemes 37 Figure 13. Green finance framework in Mongolia 41 Figure 14. Bank green lending composition by products (%) 42 Figure 15. Structure of credit information flows 48 Figure 16. Coverage of mortality index livestock insurance in Mongolia, 2006–2023 59 Figure 17. Herder segments and range of financial services based on their risk profiles 60 Table 1. Summary of key recommendations 11 Table 2. Financial sector structure 21 Table 3. Banking sector shareholding structure 24 Tables Table 4. Barriers to increasing the supply of sustainable finance from banks 42 Table 5. Data on BOM Credit Register (million MNT) 48 Table 6. Main features of the subsidy schemes 55 Table 7. Outstanding amounts of the subsidy schemes, as end of the year (billion MNT) 56 Table 8. Possible distortive effect by objective of the subsidy schemes 57 4 Building the foundations for financial sector development in Mongolia Acronyms and abbreviations ADB Asian Development Bank IPO Initial Public Offering Ministry of Economy and ADR Alternative Dispute Resolution MED Development AQR Asset Quality Review MGFC Mongolia Green Finance Corporation Mongolian National Chamber of BOM Bank of Mongolia MNCCI Commerce and Industry Ministry of Food, Agriculture and CBB Central Bank Bill MOFALI Light Industry Country Climate and Development CCDR MOF Ministry of Finance Report CGFM Credit Guarantee Fund of Mongolia MOJ Ministry of Justice Mongolian National Reinsurance CGS Credit Guarantee Scheme Mongolian Re Joint Stock Company COVID-19 Coronavirus Disease 2019 MPCI Multi-Peril Crop Insurance Deposit Insurance Corporation of DICOM MRV Monitoring, Reporting and Verification Mongolia DBM Development Bank of Mongolia MSE Mongolian Stock Exchange Environmental, Social and Mongolian Sustainable Finance ESG MSFA Governance Association FCY Foreign Currency NBFI Non-Bank Financial Institution FDI Foreign Direct Investment NDC Nationally Determined Contribution FI Financial Intermediary NGO Non-Governmental Organization FRC Financial Regulatory Commission NPCI Named Peril Crop Insurance Financial Sector Assessment FSAP NPL Non-Performing Loan Program GDP Gross Domestic Product NRP New Recovery Policy GHG Greenhouse Gases NSO National Statistics Office GOM Government of Mongolia SCC Savings and Credit Cooperative Ha Hectare SME Small and Medium-sized Enterprises HFP Housing Finance Program SOE State-Owned Enterprise HH Household SWF Sovereign Wealth Fund IBLI Index-Based Livestock Insurance TCO2e Tons of Carbon Dioxide equivalent IFC International Finance Corporation Monetary amounts are in US dollars (US$) and IMF International Monetary Fund Mongolian Tugriks (MNT). 5 Building the foundations for financial sector development in Mongolia ACKNOWLEDGEMENTS The World Bank fielded missions to Ulaanbaatar, The team is also grateful for the comments Mongolia on three occasions (April 10–26, 2023; received from Marius Vismantas, Katia D’Hulster, September 25–October 6, 2023; and April 17– Smita Wagh, Batmunkh Batbold and Jean Francois May 3, 2024) to conduct assessments of financial Bouchard to enhance the quality of the report. sector development issues and interventions The team would also like to thank the many World by the Government of Mongolia addressing Bank and IFC colleagues who provided invaluable constraints hindering access to finance for small comments and insights at the early stages in the and medium-sized enterprises (SMEs), including report’s production. those in the enabling environment, to support SME growth and economic diversification. Peer reviewers for the study were Tatiana Didier, Ketut Ariadi Kusuma and Ganbaatar Jambal. This report summarizes the main findings of the missions, identifies key financial sector The team would like to express gratitude to development issues, and provides policy Government officials and market participants, recommendations on how policymakers and including representatives of development partners regulators in Mongolia might advance the engaged in Mongolia and civil society leaders who development of the financial sector to make it generously shared their time and valuable insights work more effectively in response to Mongolia’s during the development of this body of work. greatest development challenges and achieve Special thanks are extended to the leadership and the highest possible impact in improving people’s managers, especially Mara K. Warwick, Tae Hyun lives. Lee, Zafer Mustafaoglu and Elitza Mileva, for their The principal authors of this report are Thilasoni guidance in the preparation of this report. Benjamin Musuku, Michael Fuchs, Gabriel Davel and Erdenebulgan Ganbat. The report also draws on draft material specially provided by Fatou Fadika, Qhelile Ndlovu, Grant Spencer, William Baghdassarian and Ignacio Miro. Excellent team assistance has been provided by Sukhchimeg Tumur. The report was edited by Christine Horansky. 6 Building the foundations for financial sector development in Mongolia 01 EXECUTIVE SUMMARY 1. Executive summary 7 Building the foundations for financial sector development in Mongolia 1. The financial sector has a core role to play banking sector accounting for 91 percent in increasing investments and supporting of total financial system assets. Expansion enterprise growth and entrepreneurship in of the financial sector has not kept pace non-mining productive sectors in Mongolia. with growth of the gross domestic product This study endeavors to identify and make (GDP): bank credit to the private sector as a recommendations that will address structural percentage of GDP has declined significantly impediments in the financial sector, thereby from 60 percent in 2013 to 41 percent in encouraging investment in productive 2022. On the face of it, the banking system enterprises. It champions a holistic approach seems stable, but in recent years the Bank of to transforming the financial system, aligning Mongolia resorted to conducting two asset it with the economic transformation goals quality reviews (AQRs) of banks in 2017 and of the New Recovery Policy (NRP) and 2022 to ascertain the banks’ overall financial Vision 2050 as well as the climate agenda, condition and performance, reflecting long- while emphasizing the connection between standing reservations about the effectiveness enhancing the functioning of financial markets of banking supervision. Lending to small and and promoting greater private investment. If medium-sized enterprises (SMEs) continues implemented, these reforms will contribute to to be characterized by short maturities, small strengthening the resilience of the Mongolian loan sizes, and reliance on security in the form economy, placing the financial system on a of immovable collateral. transformational development trajectory. 4. Deepening of the financial system has stalled, 2. Financial deepening has been held back as evidenced by the Government’s decision by macroeconomic instability and limited to discontinue the issuance of government structural economic transformation. This securities in 2017. The burden of funding perpetuates Mongolia’s vulnerability to the budget deficit has been passed to the boom and bust cycles linked to the impact Bank of Mongolia (BOM), the country’s central of fluctuations of primary commodity prices. bank. The BOM has become increasingly High levels of problem loans and deficiencies involved in activities that fall outside the in the enabling environment, as well as traditional mandate of a central bank. In market distortions arising from government addition to being responsible for sterilizing the support programs, also constrain financial domestic liquidity associated with funding the deepening. If Mongolia is to be placed on the Government’s foreign borrowing, the BOM has higher, more sustainable, and more equitable provided private banks with foreign exchange economic growth trajectory that is necessary swaps to relieve them of foreign exchange risk to achieve its ambition of becoming an upper- and has funded significant subsidy programs. middle-income country by 2030 and a high- The BOM’s involvement in these activities has income country by 2050, the authorities will resulted in the accumulation of significant need to address the challenges associated contingent fiscal liabilities, undermining the with financial deepening and diversifying the autonomy and authority of the central bank, economic base with greater conviction and and stymying the development of market- purpose going forward. based finance. In preparing to strengthen the autonomy and financial independence of the 3. Against the background of sustained socio- BOM, it is recommended that the authorities economic progress and improved quality undertake a thorough audit of the scope of of life, little has changed in the structure activities and financial statements of the BOM of financial intermediation in Mongolia to identify (i) the total size of outstanding since 2012. Weaknesses in credit market contingent fiscal liabilities arising from funding infrastructure and contract enforcement that the Government’s borrowing, foreign exchange had been identified more than a decade ago swaps, and subsidy schemes, including repo remain unaddressed. The financial system arrangements; (ii) the nature and extent of risks remains dominated by banks, with the 8 1. Executive summary Building the foundations for financial sector development in Mongolia that have been assumed by the BOM; and (iii) supervisors strengthened. the size of the Ministry of Finance’s obligations in recapitalizing the BOM. This audit should 6. The Ministry of Finance (MOF), working with include an evaluation of the consequences the BOM as its agent, needs to reestablish of the BOM’s extended obligations to the the government securities issuance program Government, and its compromised authority following a roadmap designed to strengthen in implementing banking supervision, on its the institutional foundations of the fixed ability to fulfill its core mandate in stabilizing income market. At the time that the issuance the macroeconomy. of government securities was discontinued in 2017, the authorities had grounds to believe 5. Strengthening the independence, governance that market actors were colluding to manipulate and oversight authority of the BOM is the price of government securities. Building fundamental to addressing banking sector on lessons learned, the authorities should pay vulnerabilities and closing gaps in market special attention to establishing sound market development. It is crucial that its mandate be conduct rules and monitoring compliance. revised to prohibit reliance on the central bank This would help develop capacity to implement for sterilizing the domestic liquidity impact practices that ensure good conduct by market of foreign borrowing (by the Government participants, including the application of strict and the private sector), financing foreign sanctions in cases of malpractice. By providing exchange swaps, and funding subsidies. The a benchmark yield curve that can be used in financial independence of the BOM needs to pricing financial assets in Mongolia, restarting be strengthened by discontinuing such quasi- the issuance program for government fiscal activities or transferring them to the securities is fundamental to advancing Government. To prevent reoccurrence, the the development of market-based finance, review of the mandate of the BOM should including climate finance (as discussed explicitly prohibit future recourse to quasi- further below). The authorities should also fiscal financing. Actions should also be taken consider the government securities program to establish a more independent, effective as part of the broader strategy to create a more and credible central bank. In this regard, the competitive and attractive investment climate BOM’s operational independence should in Mongolia. Along with regular and predictable be strengthened by focusing its mandate issuances of government securities, building on the achievement of the medium-term and sustaining market outreach is important, inflation target as defined by the Government and the authorities should seek continuous of Mongolia (GOM). At the same time, the engagement with stakeholders on the choice accountability mechanisms applied to the of instruments and structural features of the BOM should be strengthened by clarifying securities to be issued. the BOM’s core functions and responsibilities regarding macro-financial stability and 7. Parallel reforms are needed in the market for oversight of the financial system. Among the foreign exchange. In discontinuing the BOM’s measures to be considered as part of this role of serving as the counterparty to most review are adopting a more rigorous process foreign exchange transactions and provider for nomination and appointment of the BOM’s of foreign exchange risk coverage to banks, it board and management, including senior will be important to redirect foreign exchange BOM officials, that follows defined procedures, flows, so that they are channeled through the as well as establishing appropriate key interbank market, thereby stimulating market performance indicators, internal oversight, activity and liquidity. The authorities can and reporting systems that can be used to support this process by defining operational assess performance against objectives. The rules, by introducing technical infrastructure legal status of the BOM supervisory decrees that facilitates spot and forward trades, and should be clarified and legal protections for by insisting on market transparency. 1. Executive summary 9 Building the foundations for financial sector development in Mongolia 8. Restructuring credit subsidy schemes should Mongolia has put in place an advanced be a central pillar of the authorities’ efforts to green finance framework, yet capital flows resolve resource misallocations and remove to climate-related projects are low, only distortions for lenders and borrowers. The reaching 2.9 percent of bank portfolios. aggregate size of subsidy programs rolled Further progress will require (i) the removal out over the past decade is estimated to have of the distortions and disincentives created ranged between 23 and 40 percent of the by current subsidy schemes; (ii) the creation total value of lending. The Mongolian credit of public green certification, labeling, and subsidy schemes, rather than being a crisis monitoring, reporting and verification systems response, have been left in place for far too (MRV); and (iii) the unlocking of public and long, with new schemes continually being private funding for climate mitigation actions added, thereby making the schemes a largely through issuance of foreign sovereign green permanent feature of the financial system. and sustainability-linked bonds, guarantee The public has come to expect support from mechanisms, and voluntary carbon markets. subsidy schemes, and the schemes severely In the meantime, the authorities need to work distorted credit allocation and risk-based alongside the private sector to strengthen the pricing in the banking system. institutional foundations needed to support the development of the domestic bond market. 9. Efforts to reduce concentrated ownership of banks and to encourage foreign bank entry 11. It is recommended that the authorities have so far been ineffective. The strategy replace the Credit Guarantee Fund of of placing a 20-percent shareholding cap on Mongolia (CGFM), the current partial credit large shareholders should be reconsidered, guarantee fund, with an institution with a as should alleviating any related legal and broader mandate that, in addition to partial institutional constraints deterring foreign credit guarantees, includes domestic trade investment in the banking sector. A revised credit, export credit insurance, and climate strategy is needed which includes steps finance risk coverage. CGFM has had to both diversify share ownership and negligible impact since it was established improve the regulatory framework, including over a decade ago, is heavily dependent implementation of principles for vetting on external subsidies, and does not enjoy controlling interests in banks and effective the trust or support of the banking sector. supervision of complex shareholding The success of a new restructured and structures to contain the risk of both recapitalized institution and its ability to connected and related-party lending. Further, expand coverage to underserved market the updated strategy should encourage the segments will depend on the introduction of entry of new strategic investors. Encouraging a strong governance structure to raise the strategic investments in State Bank, a state- institution’s autonomy and accountability owned commercial bank, could provide for results, the adoption of sound market an opportunity to improve its governance, orientation and principles of financial self- commercial incentives, and results. sustainability, and the implementation of international best practices in all its areas of 10. The financial sector faces several obstacles operation. hindering it from playing a significant role in advancing access to climate finance. There 12. Currently, banks’ credit allocation and credit is still a lot of skepticism around the climate risk management decisions are hampered agenda in Mongolia, even as the physical by weaknesses in credit information sharing impacts of climate change are felt across and multiple shortcomings in the legal and the country and the investment demand for judicial system. This undermines contract climate adaptation and mitigation is now enforcement and the process of foreclosing on estimated at US$9.7 billion. In line with the collateral. These factors feed directly into high national commitment for climate transition, levels of non-performing loans (NPLs) and the 10 Building the foundations for financial sector development in Mongolia high costs of credit, creating disincentives for procedures, the code on enforcement of lending to the business sector and potentially judicial decisions, and in establishing out-of- hurting bank solvency and stability. Although court workout processes. The slow speed of two private credit bureaus were operational in implementing reforms is having a negative 2022, amendments of the enabling legislation effect on the NPL resolution, the cost of for credit information sharing have been borrowing, and bank solvency, thereby slowing long delayed, resulting in a situation where expansion of credit to SMEs, and the business effectiveness of the private credit bureaus is sector in general. In addition, to improve the undermined. The amendments would enable environment for asset-based finance for private credit bureaus to play a comprehensive SMEs, there is a need to review the leasing role in credit information exchange and law and the functionality of the Moveable provision of risks management and scoring Pledge Register. Since the Law on Tangible services. Changes to the legal framework and Intangible Movable Property Pledge (also are also required to support the restructuring known as the Pledge Law) came into effect of the BOM’s credit register, so that it better in March 2017, around 670,000 movable serves the needs of banking supervision and asset pledge notices have been registered in credit market monitoring. the registry (as of June 2023). Unfortunately, this has not had a significant impact on bank 13. Renewed efforts are needed to improve lending behavior, with 80 percent of bank loans contract enforcement involving both judicial still being supported by claims on immovable reform and introduction of out-of-court collateral. The use of movable property as settlement mechanisms. The authorities security is hampered by ineffective foreclosure acknowledge the urgent need for legislative procedures, even when pledges are registered reform of the civil code, the code on court on the Moveable Pledge Register. table 1. Summary of key recommendations Responsible Recommendations Time** Authorities* Strengthening central bank independence, governance and oversight With a view to preparing to revamp the mandate of the BOM as an autonomous and authoritative central bank, the authorities should procure a thorough professional and independent audit of the BOM to identify the present value of contingent liabilities arising 1 MOF & MED NT from (i) funding of the Government’s deficit; (ii) foreign exchange swaps; and (iii) subsidy schemes, including repo arrangements designed to provide banks with subsidized funding. Strengthen the operational independence of the BOM by setting a medium-term inflation 2 target. Review governor and deputy governor appointment process and enhance security MOF MT of employment, preventing untimely dismissals. In furtherance of Recommendation 1 above, the GOM to approve capital structure and 3 overall risk profile of the central bank, reinforcing the BOM’s autonomy and allowing the MOF MT BOM to focus on its core stability and supervisory mandate. In tandem with provision of greater operational independence, introduce measures 4 to strengthen the BOM’s accountability through rigorous assessment of performance MOF MT against the objectives defined by the BOM’s mandate. 11 Building the foundations for financial sector development in Mongolia Responsible Recommendations Time** Authorities* Tackling distortions and risk factors Central bank bills (CBBs) issued by the BOM to be reserved solely for short-term liquidity 5 MOF & BOM NT management purposes. Unify the foreign exchange market and phase out the BOM’s role as provider of foreign MOF, MED & 6 MT exchange hedging to banks. BOM Review and restructure all subsidy programs to ensure that remaining subsidies are 7 MOF & MED I effectively targeted and encourage crowding-in of the private sector. Develop a strategic plan for State Bank aimed at attracting strategic investors with MOF, MED & 8 NT experience in servicing SMEs and financing agri-value chains. BOM Fostering market development Implement a roadmap for restarting the government securities issuance program, providing a benchmark for market pricing, including steps to broaden the investor 9 MOF I base, specifying conduct obligations of participating dealers and market makers, and sanctions for noncompliance. Develop a holistic financial sector masterplan to gain traction for more effective implementation of financial sector policies coordinated among parties in Government, MOF, MED & 10 enhancing the contribution of the financial sector to economic transformation as I BOM envisaged under the NRP and Vision 2050, including achievement of the Nationally Determined Contribution. In furtherance of Recommendation 10 above, boost investment in the green and sustainable economy, leveraging private capital flows by: (i) reforming subsidies to more effectively target vulnerable groups such as small herders and subsistence farmers; (ii) leveraging capital markets by issuing foreign sovereign sustainability-linked bonds and green bonds; (iii) capitalizing the existing Mongolian green finance vehicle and MOF, MED & 11 MT establishing a climate finance window in the restructured guarantee scheme to de- MOFALI risk and increase the flow of private capital in climate mitigation and adaptation; (iv) investing in the creation of public green certification and labeling systems programs, including MRV; and (v) leveraging the voluntary carbon markets and livestock insurance to build climate resilience for herders. Establish a guarantee/insurance corporation to replace CGFM that has the mandate to provide partial credit guarantees, domestic trade credit insurance, export credit MOF, MED & 12 MT insurance services, and climate finance risk coverage. Products to be made available on BOM a financially sustainable basis and according to international best practices. Strengthening credit market infrastructure Expand and strengthen credit information infrastructure by restructuring the BOM’s 13 credit register and clarifying the powers and functions of private credit bureaus. Requires MOF & BOM I expeditious passage of amendments to the 2011 Law on Credit Information. Prioritize reforms aimed at improving contract enforcement through legislative changes MOF, MED & 14 NT designed to upgrade the judicial process and out-of-court settlement procedures. MOJ Improve the environment for asset-based finance by: (i) addressing weaknesses in the MOF, MED, 15 2006 Leasing Law; (ii) improving the regulatory and supervisory framework for leasing; MOJ, BOM & NT and (iii) establishing effective foreclosure procedures for perfected pledges. FRC * FRC = Financial Regulatory Commission; MED = Ministry of Economy and Development ; MOFALI = Ministry of Food, Agriculture and Light Industry; MOJ = Ministry of Justice ** I (immediate) = within one year; NT (near term) = 1-3 years; MT (medium term) = 3-5 years 12 02 CONTEXT Building the foundations for financial sector development in Mongolia 14. Limited structural economic transformation driven primarily by significant foreign direct makes the Mongolian economy vulnerable investment (FDI) in new mining projects to external shocks. For the past two decades, (Figure 1b), while growth in other sectors is Mongolia has made socio-economic progress, hindered by structural factors that hamper and the quality of life has improved, as their competitiveness (Figure 1c). This results reflected in measures such as GDP per capita in growth that is dependent on the mining and life expectancy (Figure 1a). However, sector, and limits achievement of Mongolia’s persistent macroeconomic volatility, caused growth potential, while doing little to improve by a narrow economic base and unaddressed equity outcomes. In promoting economic structural deficiencies, has hindered more diversification, the Mongolian authorities inclusive and resilient economic growth. need to limit the impact of fluctuations of Mongolia’s narrow economic base is primary commodity prices on the domestic characterized by concentrated trade flows economy (Figure 1d), while also diversifying with dominant neighboring trade partners, and the productive base so that the economy a high dependency on export of unprocessed becomes less susceptible to boom and commodities and imports of consumer and bust cycles, and more capable of fostering capital goods, including fuels and food (Figure economic resilience and creating sustainable 2). Mongolia’s economy continues to grow, domestic jobs. Figure 1. Macroeconomic developments Figure 1a. Economic welfare 7,000 72.0 GDP per capita, USD Life expectancy at birth, years RHS 6,000 71.0 70.0 5,000 69.0 4,000 68.0 3,000 67.0 2,000 66.0 1,000 65.0 0 64.0 2005 2008 2011 2014 2017 2020 2023 Source: NSO and World Bank Figure 1b. FDI by sectors 7,000 GDP composition by main sectors 72.0% 5,000 67.0% Million USD 3,000 64.0% 2010 2013 2016 2019 2022 Mining Manufacturing Construction Retall and whole sale Financial sector Other Mining share % Source: NSO and World Bank 14 2. Context Building the foundations for financial sector development in Mongolia Figure 1c. GDP composition 80,000 GDP composition by main sectors 30.0% 60,000 20.0% Billion USD 40,000 10.0% 20,000 0 0.0% 2005 2008 2011 2014 2017 2020 2023 Mining Financial sector Agriculture Manufacturing Transportation Construction Retail and whole sale Other Agriculture share % Mining share % Manufacturing share % Retail and whole saleshare % Source: NSO Figure 1d. GDP growth and the commodity price 400 50 350 Coal price index Copper price index GDP growth % RHS 40 300 30 250 20 200 10 150 0 100 50 -10 0 -20 2005 2008 2011 2014 2017 2020 2023 Source: BOM Figure 2. Trade partners and main products Figure 2a. Main Export Partners Figure 2b. Main Import Partners 323 9 23 China China Switzerland Russia Singapore 37 Japan % 4 % South Korea South Korea Others 7 Others 83 29 Source: NSO Source: NSO Figure 2c. Main Export Products Figure 2d. Main Import Products 14 Coal 37 Diesel 9 Copper 23 Cars Gold Petrol % % 54 Others 29 Trucks 23 Others 4 7 Source: NSO Source: NSO 2. Context 15 Building the foundations for financial sector development in Mongolia 15. Public sector revenues are highly dependent commodity cycle by setting aside funds in on commodity prices and exports, resulting the two sovereign wealth funds (SWFs) to be in high fiscal vulnerability to exogenous able to draw on these funds to mitigate the shocks. This procyclical feature leads to adverse consequences of the lower public strong revenue collection in the positive part of revenues during harder times¹. Unfortunately, the commodity cycle and a highly constrained the Government also acted to reduce available fiscal environment in the negative part of that buffers when it stopped issuing domestic cycle (Figure 3a). This effect is accentuated by government debt securities in 2017², resorting the shallowness of domestic financial markets, instead to financing its fiscal deficit externally which are unable to act as a buffer (funding (Figure 3c), and through sterilization financed source) during the negative part of the cycle. through the issuance of short-term central While commodity exports have risen in recent bank bills (CBBs) (Figure 3d). Fundamentally, years, they are insufficient to compensate for Mongolia is unable to generate sufficient the deficit in the primary income and services public and private sector savings to finance accounts of the balance of payments, resulting the size of its domestic investments (Figure in persistent current account deficits (Figure 3e). To close this financing gap, Mongolia 3b). Over the years, the Government has tried relies on external financing, which aggravates to build buffers during the positive part of the financing vulnerabilities. Figure 3. Financing gap and source of funding Figure 3a. Fiscal revenue and commodity price 400 Fiscal revenue and commodity index 30,000 350 Coal price index 25,000 300 Copper price index 20,000 250 Fiscal revenue billion MNT, RHS 200 15,000 150 10,000 100 5,000 50 0 2000 2003 2006 2009 2012 2015 2018 2021 Source: NSO and World Bank Figure 3b. Current account balance 3,000 0 2,000 -500 1,000 0 -1,000 2014 2015 2016 2017 2018 2019 2020 2021 2022 -1,000 -2,000 -1,500 -3,000 -2,000 -4,000 -5,000 -2,500 Balance of goods Balance of services Primary income Source: BOM Secondary income Current account (right) 1 Mongolia has two sovereign wealth funds to cushion the economy against the short- and long-term effects of the commodity cycle, but frequent recourse to the accumulated funding prevents the funds from playing a more meaningful role in smoothing the trajectory of the economy. 2 As explained later in this report, this action arose out of suspicions by authorities about collusion and manipulation of prices for government securities by market actors. 16 2. Context Building the foundations for financial sector development in Mongolia Figure 3c. External financing Government Central Bank Deposit-Taking Corporations 40,000 Other Sectors Direct Investment Intercomany Lending Gov+CB share % RHS 0.40 35,000 0.35 30,000 0.30 25,000 0.26 20,000 0.20 15,000 0.15 10,000 0.10 5,000 0.05 2005 2008 20011 2014 2017 2020 2023P Source: BOM Figure 3d. Central bank bills and the government domestic securities outstanding (billion MNT) 12,000 CB, bills outstanding, billion MNT Government domestic securities outstanding billion MNT 10,000 8,000 6,000 4,000 2,000 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 Q1 Q3 2015 2016 2017 2018 2019 2020 2021 2022 2023 Source: BOM and NSO Figure 3e. Domestic investment and savings (% of GDP) 45 40 35 30 25 20 16 10 5 0 2014 2015 2016 2017 2018 2019 2020 2021 2022 Total investment Gross national savings Source: BOM and NSO 2. Context 17 Building the foundations for financial sector development in Mongolia 16. Mongolia faces significant development including significant natural hazard risks, challenges ahead. Under the New with dzudz (extreme cold spells), droughts, Recovery Policy (NRP) and the Vision 2050, snowstorms, and wildfires all common, the Government has set the long-term alongside earthquakes and floods. Mongolia’s development goal for Mongolia to become an emission per capita (tCO2e per capita) is at upper-middle-income country by 2030 and a 17.5, just below the United States at 17.7 . high-income country by 2050. Achieving these The carbon intensity (tCO2e/million GDP) is goals would require sustained GDP growth of at 4250.9, compared to 1081.9 for Malaysia. more than 6 percent and entail overcoming To successfully shift to a more sustainable significant institutional and governance path of production will require alignment of obstacles, while seizing on new opportunities national investment plans with the country’s to encourage new investment and private commitments expressed in its Nationally sector development. Harnessing Mongolia’s Determined Contribution (NDC). The NDC economic growth potential, and leveraging commits Mongolia to reduce its greenhouse the growing demand for jobs from a youthful gas (GHG) emissions in key sectors by 22.7 population, will largely depend on the percent by 2030, and outlines a series of outcomes of efforts to diversify the economy. policies and measures for increased GHG Mongolia is still far away from developing mitigation targets to be achieved by 2030 in the institutions, markets, and governance the energy, industry and agriculture sectors. systems needed to support the process of Severe winter conditions affect livestock becoming an upper-middle-income country. populations and rural livelihoods: as an Given the dominance of extractive industries, illustration, the 2024 severe winter has led to falling commodity prices and lower revenues a loss of about 6 million livestock (9 percent can periodically result in pervasive financial of the total) and affected about 190,000 distress among interconnected borrowers, herding households. Agriculture is the leading compromising the financial health of firms contributor to GHG emissions, and the current and households across the economy. To make system of livestock subsidies has contributed progress, the authorities need to address the larger GHG emissions due to overstocking. challenges associated with diversifying the Mongolia’s rapid urbanization, driven by economic base and creating new markets in a mining growth, strains housing infrastructure, coordinated and purposeful manner. This will creating a demand-supply gap that particularly entail creating jobs and income by boosting the impacts informal settlements in ger areas competitiveness of domestic growth sectors, (underdeveloped areas in the outskirts of such as the agribusiness and services sectors. urban Ulaanbaatar). Maintaining climate Such progress is predicated on significant resilience and preventing the buildup of risks improvements in the business environment, and vulnerabilities remain major challenges. and much more effective targeting of fiscal measures designed to target productivity 18. Mongolia is struggling to build a improvements of alternative growth sectors. financial sector capable of supporting In supporting this process, the financial sector new investments and encouraging more has a crucial role to play in efficiently and diversified and sustainable activities in the effectively mobilizing long-term capital while domestic economy. Mongolia lags leading fostering resilience and inclusive growth. peer countries in channeling credit to the private sector (Figure 4a). Even though credit 17. Vulnerability to climate change adds has grown in real terms, expansion of the urgency to this transformation. Mongolia financial sector has not kept pace with GDP faces a long list of environmental challenges, growth, reducing the capacity of the financial 3 World Bank climate watch. 18 2. Context Building the foundations for financial sector development in Mongolia system to allocate financial resources within reforms, there are persistent inconsistencies the economy (Figure 4b). Even though the total indicating inadequate attention to critical assets of the banking system have grown by actions. over 100 percent in nominal terms since 2014, with a compound average annual growth 19. Financing of SMEs constitutes only a small rate of 8.2 percent, as a percentage of GDP, proportion of bank lending, and over time, banking assets have declined from over 100 SME access to finance is unstable (Figures percent in 2014 to about 85 percent in 2022. 4c and 4d). Recent surveys by the Mongolian Similarly, bank credit to the private sector as authorities highlight that access to finance a percentage of GDP – the standard measure remains a challenge for SMEs. For instance, of the banking sector’s contribution to in 2021, 45 percent of respondents to a survey resource allocation within the economy – has conducted by the BOM identified stringent declined quite significantly from 60 percent loan terms and the low valuation of collateral in 2013 to only 41 percent in 2022. Looking at their disposal as primary obstacles to back over the past decade, Mongolia has accessing credit. Lending to SMEs continues made only limited progress in implementing to be characterized by short maturities, small the recommendations of the 2012 Financial loan sizes, and heavy reliance on security, Sector Assessment Program (FSAP) (Annex predominantly in the form of immovable 1). Efforts to implement elements of the collateral. Banks are partly constrained by the reforms proposed in 2012 have stalled due to short maturity of their liabilities and the lack lack of coordinated action and weaknesses of alternative funding sources with longer in follow-through when it comes to legislative maturities, but as discussed further in the reforms, many of which have languished, following sections of this study, outside the as referenced later in this report4. Despite value chains of the extractive industry sector, authorities expressing commitment to deficiencies in the enabling environment constrain bank lending to SMEs5. Figure 4. Financial sector developments Figure 4a. Credit to private sector compared to the peer Figure 4b. Credit to private sector (% of GDP) countries (% of GDP) Domestic credit to private secter (% of GDP) Domestic credit to private (% of GDP as of 2021) 70 70 60 60 50 50 40 40 30 30 20 20 10 10 bia nia ru an an c ia a n bli oli a es Pe 10 ist st aij lom to pu g on yz Es k on b 2009 2011 2013 2015 2017 2019 2021 be Re er rg Co d M In Az Uz Ky yz rg Source: World Bank Source: World Bank Ky 4 This report emphasizes supply-side analysis and reforms. Such supply-side reforms may be insufficient to drive economic diversification. The World Bank report on “Boosting Mongolia’s Private Sector and Green Competitiveness” (June 2024) focuses on analysis of the demand side, and examines key constraints to private sector development, and policy priorities to address them (Annex 2). 5 There is room for improvement in the suitability of the finance products and services offered by the banks and non-bank financial institutions to SMEs. A re- duction in the obstacles that inhibit lending to SMEs (and recovery of loans on SME default) should encourage greater product development. Product development may well benefit from external support and knowledge transfer. 2. Context 19 Building the foundations for financial sector development in Mongolia Figure 4c. Bank lending by sectors (billion MNT) Figure 4d. Bank lending by sectors (YoY %) Bank loan outstanding by main sectors Bank loans year on year changes by main sectors, % 30,000 12% 30% 30% 25% 25% 25,000 10% 20% 20% 20,000 8% 15% 15% 15,000 6% 10% 10% 5% 5% 10,000 4% 0% 0% 5,000 2% -5% -5% -10% -10% 0 0% 2017 2018 2019 2020 2021 2022 2023 -15% -15% 2018 2019 2020 2021 2022 2023 Consumer Corporate SME loan Consumer Corporate SME loan Mortgage* Micro business loan individuals Mortgage* Micro business loan individuals Other SME share % RHS Other SME share % RHS Source: BOM Source: BOM 20. The Mongolian authorities are yet to develop assets. Although NBFIs play an increasingly a holistic financial sector masterplan to important role in the provision of new lending, drive and align development of financial they have not challenged the dominance of intermediation and enhance the contribution banks as a source of SME finance. NBFIs of the financial sector to economic lend primarily to consumers, with only 12.1 transformation as envisaged under the NRP percent of their lending going to SMEs. As and Vision 2050, including achievement of of December 2022, the loan portfolio of the NDC.6 The financial system remains NBFIs stood at MNT 2.7 trillion, compared dominated by banks, with the banking sector to the banking sector loan portfolio of MNT accounting for 91 percent of total financial 22.0 trillion. There are 15 non-life insurance system assets as of 2023, declining from companies, two life insurance companies, 96 percent in 2011 (Table 2). As of April and one reinsurance company. Both NBFIs 2024, the financial system consisted of 12 and insurance companies are regulated by the licensed banks, of which one is a state-owned Financial Regulatory Commission (FRC). The commercial bank (with an asset share of insurance penetration ratio, as measured by 8.6 percent) and 11 are domestic private the ratio of gross written premium to GDP, was commercial banks. There are no foreign only 0.46 percent in 2020 (mostly attributable commercial banks operating in Mongolia. The to the non-life insurance business). Higher decline in the share of banking system assets insurance penetration would provide greater over the past decade was accompanied by product diversity and help SMEs in managing an increase in the market share of non-bank risks, including climate change related financial institutions (NBFIs), which grew to vulnerability, as discussed further below. account for 6.8 percent of financial system 6 In 2020, the Parliament of Mongolia passed Resolution No. 21, which narrowly focused the attention of financial sector authorities on strategies to reduce loan interest rates over the period of 2020–2024. The resolution provided directions to be tackled in four thematic areas: (i) macroeconomic environment; (ii) drivers of credit risk cost, including (iii) operational expenses for banks; and (iv) capital market development and infrastructure fees. 20 2. Context Building the foundations for financial sector development in Mongolia Table 2. Financial sector structure 2011 2023 Recommendations Assets % of As Assets % of As Number (billion total share of Number (billion total share of MINT) assets GDP % MINT) assets GDP % Banks 14 9,223 96.50% 70.00% 12 57,070 91.40% 82.90% Private 13 8,991 94.00% 68.20% 11 51,701 82.80% 75.10% State-Owned 1 232 2.40% 1.80% 1 5,368 8.60% 7.80% Otner financial institutions 468 339 3.50% 2.60% 872 5,362 8.60% 7.80% NBFls 192 189 2.00% 1.40% 521 4,257 6.80% 6.20% SCCs 170 59 0.60% O. 4% 192 303 0.50% O. 4 % Insurance Companies 18 77 0.80% 0.60% 18 582 0.90% 0.80% Securities firms 88 14 0.10% 0.10% 52 219 0.40% 0.30% Other 89 n/a n/a n/a Total 482 9,562 100% 73% 884 62,431 100% 91% Source: BOM, banks and FRC Comments: NBFls, SCCS, Insurance, Securities firms data are as of the end of Q3 2023. "Other" includes mutual funds, private investment companies, asset management companies etc. The Development Bank of Mongolia (DBM), a state owned, specialized bank, has been established in 2012. As end of 2022, DBM asset before the writeoff was MNT4,015 billion. 21. The balance sheets of Mongolian banks depositors have significant foreign currency reveal high dollarization, and given few deposits in Mongolian banks (59.1 percent opportunities for foreign currency lending, of the banks’ foreign currency liabilities), high dependency on the BOM to absorb risk. while foreign currency deposits held by Banks’ foreign currency assets constituted 17 foreigners amount to 32.7 percent of banks’ percent of total assets in 2023, while foreign total liabilities (Figure 5c). Banks have a large currency liabilities were a significant portion negative net position of 119 percent of total at 33 percent of liabilities (Figure 5a). On the bank capital, representing almost 12 percent asset side, banks deposit two-thirds of their of GDP in 2023 (Figure 5d). Only with the help foreign currency holdings with the BOM and of swap agreements with the BOM are banks foreign banks, while lending only 20.2 percent able to bring their foreign currency exposures of their foreign currency assets (Figure 5b), within the prudential limits set by the BOM7. mostly to residents. On the liability side, local Figure 5. Banking sector balance sheet structure Figure 5a. Foreign exchange portion of assets and liabilities (%) Figure 5b. Banks’ foreign exchange assets 50% FX assests/ Total assets 100% Deposits Other, 7.8% with FX liabilities/ Total liabilities domestic 50% 80% banks, 8.8% Loans , 17.0% 60% Time deposits, 14.2% 40% Foreign banks 40% Deposits, 19.5% 20% 20% Bom, 32.8% 10% 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 0% Source: BOM Source: BOM 7 According to the BOM’s prudential regulations, banks are allowed to hold an open foreign currency exposure of 15 percent of bank capital for any one foreign currency and 30 percent of bank capital for each bank’s overall foreign currency exposure. 2. Context 21 Building the foundations for financial sector development in Mongolia Figure 5c. Banks’ foreign exchange liabilities (%) Figure 5d. Foreign exchange net position of banks (%) 100% -80% Net FX position (portion of total capital) -5% Other, 8.2% -90% Net FX position (portion of GDP, RHS) -7% 80% Foreign liabilities, 32.7% -100% -9% 60% -110% -11% Time deposits, 40% 24.9% -120% -13% Local depositors Cash accounts, -130% -15% 20% Demand deposits, 34.2% -140% -17% 0% 2016 2017 2018 2019 2020 2021 2022 2023 Source: BOM Source: BOM Figure 5e. Return of bank assets (%) Figure 5f. Income and expenses by main components (%) 25% 100% 20% 80% 15% 60% 41% Interest 10% FX 5% 40% 40% Other 0% 20% -5% RoAE 28 week CB bill rate Average lending Inflation -10% 0% 2017 2019 2020 2022 2023 Income Expences Source: BOM Source: BOM 22. The authorities are relying on banks to 23. According to data published by the BOM, the partially finance the deficit rather than banking sector is largely profitable, although funding this deficit through foreign sovereign a sizeable component of bank profitability borrowing alone. In turn, the BOM is partially can be attributed to earnings on public sector assuming the risks associated with the banks’ assets. As of the end of 2023, bank investment currency mismatch by offering banks access in short-term bills (CBBs) issued by the to swaps that transfer the currency risk from BOM constituted a significant proportion of the banks to the BOM (effectively providing an banking system assets (31.8 percent), slightly ‘open window’, whereby the BOM bears the risk less than the proportion of lending to the and eventual costs associated with swapping private sector (34.8 percent). In the absence foreign currency for domestic currency). These of a government securities market, the BOM swaps serve the purpose of encouraging has taken on the role of issuing significant banks to lend to domestic borrowers in local amounts of CBBs, which are absorbed by currency – potentially those SMEs that do not the banks. Indeed, the outstanding volume of have foreign currency earnings (i.e., outside CBBs now exceeds the volume of securities the mineral extractive industries). As of the issued prior to 2017 by the MOF. This is end of 2023, the estimated hedge provided by suggestive of BOM’s security issuance the BOM to comply with the regulatory limits program now serving the role of financing of 15 percent net open exposure to capital the Government, rather than the narrower amounted to about US$1.8 billion, equivalent role normally associated with issuance of to 38 percent of Mongolia’s international securities by central banks to manage liquidity reserves, significantly curtailing the size of the within the system. Banks derive a large part of reserves available to the BOM, should it need their income and expenses from their foreign to intervene to stabilize the exchange rate. currency activities. Income from foreign 22 2. Context Building the foundations for financial sector development in Mongolia exchange transactions constituted 41 percent sector assets (the top three banks’ share is of bank incomes in 2022, while expenses around 80 percent) as of the end of 20238, represented a similar portion, highlighting the which is substantially higher than in Mongolia’s significance of currency risks taken by banks peer countries (Figure 6a and Figure 6b). Even as an important earnings vulnerability (Figure though NBFIs have increased their market 5f). share over the past decade, the financial system remains dominated by banks (Figure 24. Concentration in the banking sector has 6c and Figure 6d). The exit of weak banks that implications for financial performance and show poor performance is rare, and mergers efficiency. Concentration in the banking and acquisitions have been very limited. No market is high, with the top five banks new licenses are under consideration. accounting for around 90 percent of total Figure 6. Financial sector concentration Figure 6a. Top 5 bank asset concentration, as share of total % Figure 6b. Top 3 bank asset concentration (%) as share of total % as of 2021 105 5-bank of concentration % 100 Top 3 Bank of concentration (%) as of 2021 95 90 80 85 70 60 75 50 65 40 30 55 20 10 45 2012 2015 2018 2021 n lic ia lia u bia ia sia an ija r n n Pe ub go st ne to lom to ba kh p on Es Es do er Colombia Peru Mongolia Kazakhstan re za Co M Az In yz Ka rg Kyrgyz republic Azerbaijan Indonesia Ky Source: World Bank and World Bank team estimation from bank websites Source: World Bank Figure 6c. Lending by main sectors, as share of total % Figure 6d. Lending share by main sectors, as share of total %, as of end of 2023 Q3 Loans and advances market share by main sectors % Loans and advances market share as end of 2023Q3 100 1 80 8 Khan bank 60 9 31 TDBM Golomt bank 40 9 NBFIs % XAC bank 20 11 State bank Small banks 17 SCCs 0 2017 2018 2019 2020 2021 2022 2023Q3 15 D-SIBs Small banks NBFIs SCCs Source: FRC, World Bank team estimation from bank websites Source: FRC, World Bank team estimation from bank websites 8 World Bank team estimation from bank websites 2. Context 23 Building the foundations for financial sector development in Mongolia Table 3. Banking sector shareholding structure Bank assets to Bank loans to Bank deposits Shareholding structure as of end of April 2023 Bank name total % total % to total % As end of 2023Q3 Shareholder % HS holding+HS international 49.8 Khan bank 33% 36% 34% Tavanbogd trade+Khulan 36 Other investors less than 20% 14.2 Globull investment 60.8 TDBM 21% 19% 2% TDB capital 29.7 Other investors less than 20% 9.5 Golomt Golomt financial group 77.2 19% 17% 20% bank Other investors less than 20% 22.8 MOF 49.3 State bank 8% 10% 9% DICOM 45 Public 5.7 Xac bank 9% 10% 8% Other investors less than 20% 100.0 Small banks 10% 9% 8% n/a n/a Source: World Bank team estimation from bank websites 25. The ownership structure of Mongolian banks 26. In gaining a more thorough understanding of is inward-looking, pointing to longstanding the solvency of Mongolian banks, the BOM concerns of reputable investors relating to resorted to conducting asset quality reviews institutional and governance weaknesses (AQRs). AQRs of banks have been undertaken in the banking sector (Table 3). There is twice in recent years (in 2017 and 2022) to verify no foreign bank presence, although there the quality of bank assets and the true size are foreign investors in local banks, which of the NPL problem, and to clarify the banks’ in many cases have links to local groups overall financial condition and performance. as ultimate beneficiaries (Annex 3). These However, there has been little, if any, follow investors include large corporate groups through based on the AQRs in the form of with non-financial businesses that have supervisory remedial action. This points to the parallel shareholdings in banks, which could strong economic and political standing of the well be regarded as inappropriate were the largest banks and the compromised autonomy banks subject to consolidated supervision. of the BOM, substantiating reservations about International experience shows that such the effectiveness of banking supervision. opaque ownership structures are a significant Partly because of zero risk-weighting on risk and bank supervisors may be unaware banks’ investments in public sector assets, of the nature and extent of relationships the capital adequacy ratio reported by banks and transactions between the corporate since 2014 has been over 15 percent (Figure group’s businesses and the bank, which may 7a). According to data published by the BOM, compromise the bank’s financial condition banks’ NPL ratios have fluctuated between 7 and performance9. This opaqueness may and 13 percent in the period from 2016–2023; also provide opportunities for those with with NPL on SME loans varying in the range controlling stakes in banks to use banks to of 10-15 percent, with a high of 27 percent in provide undisclosed support to non-financial the COVID-19 period (Figure 7b and Figure 7c). businesses or mask the true risks within the This high level of NPLs is a factor significantly group. discouraging SME lending. 9 Connected counterparties are linked to the ownership structure or to economic dependence. Connected counterparties often have the same group affiliations. Related counterparties are broader; there can be a group affiliation, but often there is none. Related party transactions often are a source of abuse by bank share- holders and executives. So, complex shareholding structures have a risk of both connected lending and related party transactions. 24 2. Context Building the foundations for financial sector development in Mongolia Figure 7. Financial sector asset quality Figure 7a. Bank capital adequacy ratio by D-SIBs (%) 24.0 Capital adequacy ratio % 22.0 20.0 18.0 16.0 10.0 14.0 12.0 10.0 2017Q4 2018Q4 2019Q4 2020Q4 2021Q4 2022Q4 2023Q4 Khanbank Golomt TDBM State ХАС BOM requirement Source: Bank websites Figure 7b. Bank non-performing loans to gross loans (%) 25.0 Bank non-performing loans to gross loans (%) 20.0 15.0 10.0 5.0 2012 2013 2014 2015 2016 2017 2018 2019 2020 Estonia Colombia Peru Mongolia Indonesia Uzbekistan Kazakhstan Kyrgyz republic Azerbaijan Source: World Bank and BOM Figure 7c. Non-performing loans by main sectors (%) 14.0% Non-performing loans by main sectors % 12.0% 10.0% 8.0% 6.0% 6.0% 2.0% 0.0% 2011 2014 2017 2020 2023Q3 Source: BOM and FRC add DBM 27. While the BOM has mandated measures to the credibility of the BOM’s reform efforts. As improve the governance and management of expected, a number of interested parties and banks, these have not been fully implemented, stakeholders have questioned whether the and their effectiveness is questionable. existing plan is feasible. The December 2023 According to the amended Banking Act deadline limiting any single ownership stake (2022), banks are supposed to enforce a limit to 20 percent was missed and expectations on any single ownership stake of 20 percent. are that a new timeline will be announced. While the five largest banks have listed part More fundamentally, the impact of the single of their equity, the adoption of the size limit ownership limits is easily compromised if final on ownership stakes was delayed, eroding beneficiary owners are not properly identified 2. Context 25 Building the foundations for financial sector development in Mongolia and monitored. In addition, it is unclear that curve for various maturities of government limiting maximum ownership of any single securities, which provides a benchmark for party to 20 percent would attract reputable setting prices on domestic financial assets, is investors, as the role of new shareholders will absent in Mongolia. Underdevelopment of the be determined by the extent to which measures institutional investor base also contributes to are taken to protect minority shareholders and limiting market development and dynamism. improve the enabling environment for private investment in Mongolia. In parallel, the GOM 29. The stalled development of local financial has not publicly committed to substantially markets can to a large extent be attributed reducing its own stake in State Bank, a stated- to the discontinuation of the issuance of owned commercial bank, but has exempted government securities in 2017. As mentioned itself from the application of the new policy previously in this report, the Government capping bank shareholdings at 20 percent. stopped issuing domestic securities in 2017, Finally, the role of Initial Public Offerings (IPOs) resorting instead to financing its fiscal deficits in diversifying the ownership of banks will externally and through the issuance of CBBs also likely be compromised by limited liquidity (Figure 3c and 3d). As a result, the BOM bears in the equity market. At this stage, the GOM both the interest costs of issuing CBBs and could take the lead by reducing its stake in the costs associated with foreign exchange State Bank, thereby promoting investment by swaps required to relieve banks of their foreign reputable private parties in the banking sector. exchange exposure resulting from their foreign borrowing. These commitments weaken 28. Market-based financial development has the BOM’s balance sheet and its financial largely stagnated, as reflected by very independence. In addition, since 2012, the shallow equity and capital debt markets. BOM has executed subsidy programs on In large part, this reflects the abandonment behalf of the Government that are quasi-fiscal of the Government’s efforts to develop the operations, especially the Housing Finance fixed income market in 2017. Capital markets Program (HFP) and repurchase agreements are shallow, restricting diversification of funded at subsidized interest rates used to funding sources and limiting access to long- direct subsidized funding to certain priority term finance. The market capitalization of segments. The BOM’s involvement in these the Mongolia Stock Exchange (MSE), as of activities has contributed to expanding its September 2023, was below 15 percent of balance sheet and to the accumulation of GDP (approximately US$3 billion), much losses, resulting in negative equity (Figure 8b). lower than in many peer countries (Figure 8a). Since the government securities program was The assets of banks and NBFIs are roughly discontinued, issuances of CBBs, primarily six times larger than the MSE’s market with 4-week and 28-week maturities, have capitalization with recent improvement in seen a notable increase. While the issuance market capitalization being attributable to the of CBBs became necessary to sterilize large bank IPOs mandated by the BOM. The the impact of foreign borrowing by the corporate bond market is small as there have Government and banks on domestic liquidity been only a few issuances. Were Mongolia’s (Figure 8c), the interest costs associated with financial system more developed, domestic CBB issuances, in turn, increases the quasi- financial markets could provide a buffer that fiscal deficit of the BOM. The BOM’s balance could be drawn upon to lessen the impact of sheet underestimates the size of these losses, the investment/savings gap. The shallowness as some of them, such as on outstanding of domestic financial markets limits the role foreign exchange swaps, are contingent and played by the financial sector in providing are only reflected once they are realized. resilience against external shocks. The yield 10 M2 expanded 9.4 percent, 10.8 percent and 26.3 percent in 2021, 2022 and 2023 respectively. 26 2. Context Building the foundations for financial sector development in Mongolia Figure 8. Central bank bills, debt capital market and the government capitalization 8a. MarketSource: NSO of listed domestic companies (% of GDP) 80 70 60 50 40 30 20 10 2005 2008 2011 2014 2017 2020 Indonesia Colombia Peru Mongolia Kazakhstan Source: BOM and NSO Figure 8b. Central bank balance sheet (billion MNT) 40,000 0 30,000 -1,000 20,000 -2,000 Billion MNT 10,000 -3,000 0 -4,000 -10,000 -20,000 -5,000 -30,000 -6,000 2012 2015 2018 2023 Foreign assets Claims on banks Claims on the Government Claims on other sectors Other assets Monetary base Central Bank bills (net) Foreign liability Other liabilities Equity Source: BOM Figure 8c. Central bank bills by maturity (billion MNT) 10,000 CBB outsanding at the of year, billion MNT 9,000 8,000 1 week 4 weeks 7,000 12 weeks 28 weeks 6,000 5,000 4,000 3,000 2,000 1,000 0 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Source: BOM 2. Context 27 STRENGTHENING CENTRAL 03 BANK INDEPENDENCE, GOVERNANCE AND OVERSIGHT Building the foundations for financial sector development in Mongolia 30. To encourage deepening of domestic arm of the Government. Apart from pursuing financial intermediation, it will be crucial its primary functions of maintaining price and to create greater confidence in the stability financial stability, the BOM has been a major of the Mongolian financial system. vehicle for government support schemes and Strengthening the role of the Government directed lending in the real economy. These as an enabler of financial deepening, and schemes were boosted during the COVID-19 enhancing the contribution of the financial pandemic. Some are still ongoing, such as the system in supporting economic development, sizeable HFP, which the Government aims to is at the core of sustained economic growth transition out of the central bank. The BOM and macroeconomic stability. Strengthening dominates the markets for foreign exchange, central bank governance should be an essential gold, and foreign exchange swaps. The BOM’s element of these efforts. Mongolia’s history of involvement in these markets, and its quasi- macro-economic volatility reduces growth in fiscal activities, have led to the expansion domestic financial intermediation, limits the of the BOM balance sheet, which is heavily attractiveness of Mongolia as a destination burdened with non-core assets and liabilities for domestic and foreign direct investment, (total assets are close to 40 percent of GDP) and is adding to Mongolia’s risk premium and many loss-making activities. The capital and thereby its borrowing costs. The Bank of the BOM is deeply negative (estimated of Mongolia executes quasi-fiscal operations at close to 10 percent of GDP) and on a on behalf of the Government, pointing to downward trend. Individual balance sheet the limited operational independence of items are opaque with respect to the central the central bank. Central bank credibility banking functions they support and the overall stands as perhaps the most crucial variable financial position of the BOM is unsustainable. in understanding the various ways through The passive and quasi-fiscal role played by which the monetary sector influences the the BOM reflects poorly on Mongolia’s public financial sector. The effectiveness of the sector financial management and is a factor BOM in controlling inflation and ensuring adversely impacting Mongolia’s international financial stability is deeply intertwined with its credit rating. The current governance perceived credibility and reflected in country structure does not provide the BOM with the risk assessments by rating agencies. While arms-length operational independence that is Mongolia is seeking to boost economic growth implicit in the current Central Bank Law and is based on foreign direct investment aimed at required if the BOM is to effectively perform in diversifying the economy beyond exploitation its mandate. of mineral resources, foreign investors are cautious. They need to be confident of future • Strengthen the corporate governance economic and financial stability, including framework for the central bank to limit about the quality of governance, before they political influence. An indicator of political make long-term capital commitments. The influence over the central bank is reflected in the BOM is a central player in the macro-economy high turnover of governors, and limited ability and the financial sector, and improvements by the BOM to enforce supervisory actions in governance of the central bank have the or to use judgement in enforcing supervisory potential to significantly improve macro- actions. Very few governors have served their economic management and set the scene for full six-year term. The length of the term of renewed foreign investment and growth. BOM governors was originally intended to put governor appointments beyond the influence 31. It is advisable that the authorities adopt a of the electoral cycle. Similarly undermining phased approach to improving central bank the autonomy of the BOM, supervisory governance: actions have been deferred or overruled by the courts and other arms of the Government. • Strengthen central bank independence to The implications of the curtailed autonomy of ensure the BOM does not act as the financial 3. Strengthening central bank independence, governance and oversight 29 Building the foundations for financial sector development in Mongolia the BOM were highlighted by recent efforts BOM’s policy would then be guided by this to adopt a ‘risk-based’ approach to prudential framework and, in its quarterly ‘Monetary supervision focused on contingent liabilities Policy Statements’, the BOM would be and strategic risk. These efforts are stymied obliged to report on its progress toward by the curtailed autonomy of the BOM to take achieving the target set out by the GOM, decisions based on judgement in the exercise together with policy decisions, analysis, of its prudential oversight of the banking and forecasts of future conditions. system. • Every effort should be made to empower the • To establish a more independent, effective, BOM in the exercise of its responsibilities and credible central bank, a range of regarding the regulation and supervision issues needs to be addressed. As outlined of the banking system. For example, it below, these issues relate to four areas would be within the BOM’s remit to set that should be reviewed and considered for capital adequacy risk weights based on reform: (i) strengthening the BOM’s policy objective credit risk assessments. The independence; (ii) extending the scope of legal status of BOM supervisory decrees the BOM’s mandate on financial stability, (iii) would need to be clarified, confirming the strengthening the BOM’s balance sheet and BOM’s autonomy in issuing such decrees. financial independence; and (iv) strengthening The legal protections for supervisors the BOM’s accountability: would also need to be strengthened. • Strengthening the BOM’s operational • An important area to review is the independence for achieving medium-term appointment process for the governor and objectives set by Parliament: In holding deputy governors. To make the process the BOM accountable for its actions, it more objective, it will be important will be advisable to give the BOM more to clearly separate nominations and operational independence in achieving appointments. Nominations could be by medium-term objectives set by Parliament. the Standing Committee or by the Minister In this context, it will be appropriate to of Finance, while appointments would review and strengthen the structures for be under the purview of the Government holding the BOM accountable for its policy rather than Parliament as is now the case. performance (as explained further below). Minimum requirements, in terms of skills and experience, could be set down in the • There is good reason to review the primary Law. Governors would be expected and objective of monetary policy as set out in encouraged to complete their full six- Article 4 of the Central Bank Law, shifting year term, and strict requirements would emphasis from exchange rate stability to be introduced regarding circumstances price stability, and thereby reinforcing the under which already appointed senior BOM BOM’s current approach of pursuing a officials can be subjected to dismissal. medium-term inflation target. • Extending the scope of the BOM's • In providing the BOM with more mandate to financial stability functions: responsibility accompanied with greater Access to sustainable finance for accountability, it would be advisable economic players is directly linked to that the GOM replace the current annual financial stability, which is why most Monetary Policy Guidelines framework central banks now have a legal mandate with a more ‘arm’s length’ approach issued to maintain financial stability. With by the GOM, setting out its medium-term regards to the BOM, two functions around inflation target and related details. This financial stability are underdeveloped, would be a simple document reviewed and this shortcoming may impede the infrequently, say every four years. The financial system from playing an effective 30 3. Strengthening central bank independence, governance and oversight Building the foundations for financial sector development in Mongolia role in economic development. conflict of interest between the BOM’s core mandate of preserving price and financial • The first is the conduct of a dynamic stability and the continuation of the BOM’s macroprudential policy, with reinforced lending to the private or SOE sectors. The monitoring of systemic risks and the HFP should be removed from the balance implementation of macroprudential sheet as planned and other credits to the instruments intended to smooth the credit private and SOE sectors should also be cycle and guarantee continued access to removed or stopped. The BOM should bank financing by establishing buffers only retain credits to government and to that can be drawn upon during periods of banks at the BOM’s discretion (i.e., where stress through macroprudential policy. they are needed for monetary policy and • Another shortcoming in the BOM’s financial stability purposes). mandate is bank resolution. Today, the • The current large losses incurred by the rules relating to the function of the BOM BOM in undertaking monetary policy as a resolution authority are still poorly operations need to be closely reviewed defined, and in the event of a financial and rectified. Two aspects deserve crisis, the absence of a well-established attention. First, the high level of the BOM’s resolution regime, including the resolution funding liabilities reflect foreign exchange tools recommended by the Financial swaps designed to relieve domestic Stability Board, could result in aggravated banks of the foreign exchange risks losses, the allocation of which would associated with their foreign borrowing. A pose a problem. This uncertainty over the concerted effort is required to strengthen handling of crisis situations is a factor macroeconomic management to reduce slowing down the development of the the current account deficit and reliance on financial sector. private portfolio inflows required to bolster • Strengthening the BOM’s balance Mongolia’s international reserves. Such sheet and financial independence: An measures will support greater domestic independent BOM should control its own savings and the restarting of the GOM’s assets and liabilities and the financial domestic debt program¹¹. The policy transactions it undertakes. The GOM, as recommendations described in this report owner of the BOM, should approve the are designed to make finance work for capital structure and overall risk profile Mongolian economic diversification, and of the central bank, but the GOM should will contribute to strengthening Mongolia’s not be allowed to direct the central bank current account and support the process to undertake specific transactions. It is of achieving improved macroeconomic important that the GOM fully accepts and balance. adopts this principle, which should be • While the priority should be to eliminate enshrined in the BOM Law. To reinforce the ongoing losses of the BOM, it is also the BOM’s independence and allow the important that the BOM be recapitalized central bank to focus on its stability within a short to medium timeframe. mandate, the BOM’s quasi-fiscal activities This will be necessary to demonstrate should be discontinued or transferred to to international markets that the BOM’s the GOM. The BOM needs to stay focused balance sheet integrity has been restored on fulfilling its mandate of preserving price and is no longer compromised by and financial stability. There is a direct contingent and hidden liabilities. Restoring 11 As mentioned elsewhere in this report, restarting the government securities issuance program is also important for establishing a risk-free interest rate curve as a reference for the development of private debt and equity markets. In addition, establishing a domestic risk-free interest rate will facilitate the process of pricing foreign exchange swaps, which are important to the BOM in managing domestic liquidity. 3. Strengthening central bank independence, governance and oversight 31 Building the foundations for financial sector development in Mongolia the soundness of the central bank balance should be. A clear set of objectives needs sheet will encourage the upgrading of to be defined for the BOM’s core functions Mongolia’s international credit rating and and accountability structures, so that BOM help to reduce the cost of risk capital both management can be held responsible in for the GOM and the private sector. the case of non-performance or under- performance, while at the same time • Strengthening the accountability of the providing bank supervisors with the legal BOM: Governments create independent protections necessary for them to carry central banks and regulatory bodies out their tasks in a neutral and objective primarily to ensure that decisions are manner, protecting them from political made by those with expertise and influence. Accountability mechanisms detached from private interests and should incentivize regulators to develop political influence: central banks and and apply their expertise, to operate their supervisors are responsible for the efficiently in pursuit of their mandate, and delivery of public goods. They need to to function in a transparent and accessible be assigned appropriate objectives and manner. The primary accountability be accountable to the public regarding mechanism should be through the achievement of these objectives. processes for appointment of the governor Independence is key to supporting the and deputy governors. As outlined above, effectiveness in expert-made decisions. more rigorous process should be adopted In general, central banks should be for nominations and appointments. There able to ‘explain and justify’ to external are many other good practices when it stakeholders, such as the government, comes to central bank accountability parliament, and the public, how their that the BOM and Government should actions have contributed to accomplishing consider, such as public hearings, more their mandate. Accountability is thus the transparency, proper internal oversight opposite side or inverse of independence; and governance, regular reporting, and key the more independent an authority, the performance indicators. stronger the accountability requirements 32 3. Strengthening central bank independence, governance and oversight TACKLING DISTORTIONS 04 AND RISK FACTORS Building the foundations for financial sector development in Mongolia 32. Underpinning efforts to strengthen the multilateral market to emerge. The foreign governance of the BOM, the issuance of exchange market is fragmented, as foreign CBBs should be reserved solely for liquidity currency flows from state-owned enterprises management. As mentioned earlier, the (SOEs) are segregated from flows generated program of government securities issuance by private sector entities. SOEs are obliged was stopped in 2017 and outstanding to sell their foreign currency receipts to the government securities accounted for less BOM. Importers can bid for foreign currency than 1 percent of GDP as of December 2023, from the BOM at periodic auctions. This set- declining continuously since 2017. The up results in the BOM being the counterpart share of government securities outstanding to almost all foreign exchange transactions in peaked at 23 percent of GDP in 2016. Since Mongolia, effectively establishing a bilateral 2017, the BOM has stepped in and started market, with banks on one side and the BOM issuing equivalent or larger amounts of on the other. This prevents a multilateral CBBs, underlining the quasi-fiscal character market from developing, as private sector of the BOM’s security issuance program. parties transact primarily with the BOM and The increased interest costs associated not one another (Figure 9). The BOM’s role with the expansion of the BOM’s security as provider of foreign exchange hedging to issuance program are a heavy burden to the banks needs to be phased out by placing BOM’s balance sheet. The accumulated cost greater reliance on market-based hedging of servicing CBBs represents a contingent mechanisms and reducing the significant fiscal liability, which will eventually need to contingent liability borne by the central bank. be realized to recapitalize the BOM. The MOF In tandem with the unification of the foreign needs to re-open the market for government exchange market, the role of the central securities to support development of a bank as the sole hedger of foreign currency benchmark yield curve, while also anchoring positions should be phased out to permit the regulatory and oversight practices that ensure full development of derivative markets. This good conduct by market participants. will allow the reduction of accumulated quasi- fiscal contingencies of the BOM arising from 33. The BOM needs to phase out provision of the existing foreign currency swaps with the foreign exchange hedging to banks and unify banking system. the foreign exchange market by allowing a Figure 9. Current structure of the foreign exchange market Banks do not fully participate in Exporter Exporter - SOE the FX market and hence do not Private sector fulfill their role Commercial banks BoM Must deposit Must sell its FX (or sell) its FX to BoM in commercial banks Importer, debtor in FX etc. Importer, debtor in FX etc. Must buy from Must bid in BoM FX commercial FX etc6 There are no direct links between the private and SOE markets for auction design currency or between exporters and importers, resulting in a fragmented price formation process 34 4. Tackling distortions and risk factors Building the foundations for financial sector development in Mongolia 34. Expanding and strengthening basic forward-looking roadmap that balances infrastructure will be required to enable the benefits of development of the foreign development of currency markets. Shifting exchange market with the need for banks to the management of foreign exchange flows stay within the allowed limits on their foreign through the interbank market would stimulate exchange risk exposure. Secondly, the BOM market activity and enable development should work together with the banking sector of deeper and more liquid markets. Policy to develop a multilateral market. This will measures placing greater reliance on the involve (i) defining operational rules; (ii) setting interbank market would need to be adopted up technical infrastructure to support spot and gradually to avoid disruptions. Shifting away forward trades; and (iii) determining practices from the dominance of the BOM in the foreign in such areas as market transparency, exchange market, including in the market minimum margins, and for resolving problem for foreign exchange swaps, would need transactions. Such actions will need to be to be supported by an agreed roadmap for articulated in formal agreements, setting out establishing the market and introducing a the banks’ commitments in terms of providing code of conduct for market making, so that market liquidity, while respecting limits on their banks can manage their foreign exchange foreign exchange positions, possibly within an risk throughout the transition period. The first integrated market where banks assume the step would be to gradually reduce the role of role of market makers (Figure 10). the BOM according to a well-communicated, Figure 10. Envisaged future structure of the foreign exchange market Sale of FX obligations fo about USD 1.7 bn BoM is the main seller of dec-2022 with FX Reserves of USD 3.4 bn foreign currency derivatives enabling banking sector compliance with BoM’s the prudential BoM FX rules Significant FX BoM dervatives compensate banks deposits for their short positions Depositor Banks Creditor Foreign banks Smaller FX loans and investments Significant FX loans Banks able to reduce their short positions in FX due to hedge provided by BoM 35. It will be important to review and restructure schemes coincided with critical periods, such the subsidy schemes to encourage as during the period of the Price Stabilization crowding-in of the private sector and reduce Program, when credit growth was stagnant market distortions. The size and range of (between 2014 and 2016 when growth in subsidy schemes implemented over the past aggregate outstanding credit was only 0.7 decade has contributed to significant market percent; between 2018 and 2020 when distortions and resource misallocation (Annex growth in aggregate credit was 2.5 percent; as 4). The aggregate size of subsidy programs well as during the COVID-19 pandemic), and rolled out over the past decade is estimated played a role in maintaining the flow of credit to have ranged between 23 and 40 percent of (Figure 12). However, mortgage loan subsidy total loan values, averaging 30 percent of total programs have become a permanent feature loan values (Figure 11). The growth of the of the financial system, and borrowers have 4. Tackling distortions and risk factors 35 Building the foundations for financial sector development in Mongolia come to expect to receive credit on subsidized of available financial resources and the terms. As a result, it is likely that lending riskiness associated with lending to various to the targeted market segments would segments, the subsidies encourage financial contract if the subsidies were withdrawn. At intermediaries to allocate credit based on the same time, bank credit is diverted away level of support provided by the available from market segments that are subsidized subsidies. This is highly distortive and and where the need may be greater. Rather severely undermines the efficient allocation of than being determined by the relative scarcity resources in the economy. Figure 11. Subsidy schemes impact on bank lending (billion MNT, %) Bank loan outstanding excluding the subsidy schemes billion MNT Subsidized loan outstandings billion MNT Subsidized Mortgage Loans transfered to MIK billion MNTW Subsidies as share of total outstanding loans % right axis 35,000 45% 40% 40% 30,000 37% 35% 34% 34% 25,000 30% 29% 27% 26% 27% 27% 20,000 25% 24% 23% 15,000 20% 15% 10,000 10% 5,000 5% 3% 0 0% 0% 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Source: BOM, KPMG and World Bank team estimation 36. The subsidy schemes suffer from design designed to support catalytic structural weaknesses and fail to address core market changes that facilitate credit provision by the failures. The interventions implemented private sector. It is recommended that as part during the 2012–2016 and 2018–2020 periods of the proposed financial sector masterplan, were funded by the BOM (as Government the Government commits to a time-bound contingent liabilities on its balance sheet), rationalization and eventual discontinuation while the COVID-19 response measures in of all government subsidy programs. As 2021–2022 were funded by the Government. referenced above, this masterplan should be Irrespective of the source of funding, aimed at driving and aligning development opportunities to support market development of financial intermediation, addressing – by strengthening credit information sharing, institutional weaknesses, and reforming all the environment for asset-based finance, or government subsidy programs to be aligned contract enforcement – were not given high to economic transformation and climate priority. Provision of subsidies became a transition as envisaged under the NRP and permanent feature as mentioned previously Vision 2050, including achievement of the NDC in this report. Endeavors to improve the and building climate resilience for herders in enabling environment are fundamental to the livestock sector (see Annexes 5 and 6 for strengthening private sector incentives, so further details). that banks and NBFIs are encouraged to service the needs of the broader business sector and not only those benefiting from the subsidies. Rather than becoming a permanent feature, subsidies should be 36 4. Tackling distortions and risk factors Building the foundations for financial sector development in Mongolia Figure 12. Chronology of the subsidy schemes 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 Quasi fiscal activities and subsidy programs .... Quasi fiscal activities Construction Materials Fuel sub-program Food Storage Capacity Increase Coal sub-program Meat sub-program Trade Logistics and Facility Flour sub-program Supply of Construction program Subsidized Mortgage Program ASEM Cashmere DBM Good program TARP Subsidy programs during and after COVID Job support Agriculture support Aviation sector support Long term repo finance Cashmere support Flour production support Local business support Meat stockpile program Subsidy programs planned and/or started recently Food supply Cooperative movement White Gold Program Source: BOM, KPMG and World Bank study team estimation 4. Tackling distortions and risk factors 37 05 FOSTERING MARKET DEVELOPMENT Building the foundations for financial sector development in Mongolia 37. Reestablishing the issuance program the domestic market into account, including of government securities is essential to the investment preferences of both foreign building a liquid yield curve for government and domestic investors as mentioned earlier. securities, which is the foundation of market- Market outreach and ongoing engagement based finance. Due to the highly concentrated with market participants about the choice and structure of the banking system, suspicions structural features of securities to be issued arose regarding the manipulation of prices on will be essential. Given past experiences, the government securities, giving the authorities role of banks in the market will need to be cause to discontinue issuance of government carefully considered, including defining their securities altogether¹². Thus, in reopening obligations as dealers and market makers. the market, it will be advisable to consider Mechanisms will need to be put in place to broadening the investor base in government ensure regulation and oversight of market securities as much as possible, including participants, including graduated sanctions encouraging participation by domestic and in the case of any malpractice. Finally, it is foreign investors and retail bidding. Broader worth underlining that it will be essential to participation can be encouraged by enhancing harness broad commitment and support of securities market infrastructure, including policymakers and market stakeholders for custodial and payment services, to simplify the relaunch of the government securities the process of investment and make it more issuance program. This is because another convenient for smaller, less sophisticated round of reform reversals or ineffective reforms retail investors to trade government securities would significantly damage credibility of the and settle transactions with finality. In this efforts and undermine investor confidence in regard, it will be advisable when restarting Mongolia’s capital debt market. the government securities program that instruments to be issued target foreign 39. The transition to a low-carbon and greener investors and meet the demand of retail economy is a necessity for Mongolia. The investors. country faces a long list of environmental challenges, as mentioned previously in this 38. All in all, the government securities program report. Mongolia’s emission per capita (tCO2e should be a part of a broader strategy per capita) is at 17.5, just below the United designed to create a more competitive and States at 17.7¹4. The carbon intensity (tCO2e/ attractive investment environment. The MOF million GDP) is at 4250.9, compared to 1081.9 should develop a detailed multi-year roadmap, for Malaysia. Coal mining and the livestock including a list of actions required to deliver a sector (with its herd of 71 million) continue reconstituted government securities issuance to be a subject of concern, given their level program that clearly identifies priorities and of methane and GHG emissions and their responsibilities, including coordination with negative impact on air, soil, land, and water. market participants regarding an appropriate Many other socio-economic challenges – issuance plan. This plan will need to including food insecurity and dietary issues, include an annual borrowing plan reflecting declining competitiveness of the cashmere information on the Government’s fiscal and dairy industries, migration to cities, situation and financing strategy¹³. In addition housing issues, and the energy gap – have to considering objectives such as managing been correlated to climate challenges. A strong funding and refinancing risks, the issuance commitment was made by the Government to plan will also need to take development of transition to a low-carbon economy. Mongolia 12 While the BOM took over this function from the MOF, it is unclear whether the BOM was better able to manage market collusion impacting pricing of CBBs than the MOF in the case of government securities. 13 The 2022 and 2023 state budgets included plans for the MOF to borrow domestically MNT 683 billion and MNT 2,274 billion, respectively, but these plans were never executed. 14 World Bank climate watch 5. Fostering market development 39 Building the foundations for financial sector development in Mongolia has ambitions to reduce GHG emissions by 32 billion. The private sector will need to make percent, with the objective to reduce pollution substantial investments to adapt to climate and improve air quality by 80 percent. This change, which is already impacting many is critical from the environmental protection businesses in extractives, manufacturing, perspective and for the country’s economic agriculture, livestock, wholesale and retail, and growth. hotels/accommodation. Increasing climate investments will require more than public 40. Mongolia now faces the critical question of funding. Currently, the Government’s climate- how to ensure that the development of the related expenditure is at 0.3 percent of GDP¹5, non-mining sectors is not disrupted further so just about even with 0.2 percent of the by climate change. Resource depletion has financing needs for the climate transition. This already started to harm trade and livestock – makes the need to leverage private capital two key drivers of the nation’s robust growth in flows pivotal. As also underlined in the CCDR, recent decades. No clear targets seem to be set Mongolia will need to leverage domestic up for adaptation investments in key sectors, and international private and concessional including livestock, cashmere, transportation, resources to accelerate its climate transition and biomass. This could compromise the and mitigate the physical risks. country’s ambition to increase the processing of raw materials, such as leather, wool and 42. Considerable efforts have been made to cashmere, to 80 percent by 2030 and increase create an enabling framework for climate its participation in global value chains as finance¹6. Indeed, Mongolia has one of the indicated in the national plan. Farmers, herders, most advanced green finance frameworks and manufacturing businesses are already in place. In 2018, the Mongolian Sustainable paying a heavy price for under-investments Finance Association (MSFA), with the support in climate adaptation and resilience through of the IFC, introduced the national sustainable losses of their herds, revenue losses, finance roadmap, which provides a vast reform increasing migration towards cities, supply agenda for the financial system to embed chains issues, and difficulties to grow their sustainable finance in banking, insurance, processing. Given the growing pressures for and capital markets. Since then, the following global chains to comply with environmental, have been adopted: (i) integration of ESG social and governance (ESG) standards and standards, including ESG risk management low-carbon emissions, without embracing a guidelines and ESG reporting guidelines; new paradigm with the decarbonization and (ii) introduction of green bond regulation adaptation of the whole Mongolian livestock, and principles as part of the company debt cashmere and manufacturing industries, in instrument registration regulation (which will addition to the energy sector, the country require some prioritization and sequencing of might lose its competitive edge and see its reforms relating to restarting the government exports affected. securities market to provide benchmark for the long-term market); (iii) launch of the green loan 41. The Mongolia Country Climate and statistics; (iv) adoption of a green taxonomy; Development Report (CCDR) estimates that and (v) sustainable finance principles, along the measures to respond to climate change with training, guidelines, tools, and capacity across sectors require at least US$9.7 building to the financial intermediaries. The billion worth of investment from the private framework was adopted by all banks, with the and public sectors over the next 25 years. expansion to non-banks since 2021. Financing needs by 2030 is estimated at US$3.8 15 Mongolia Country Climate and Development Report, World Bank 16 These activities benefitted from an extensive programme of support implemented by the IFC. 40 5. Fostering market development Building the foundations for financial sector development in Mongolia Figure 13. Green finance framework in Mongolia Overarching Sustainable ESG frameworks finance Mongolia Sustainable ESG risk management Green taxonomy finance principles guidlines Green bond framework National Sustainable ESG risk management Climate risk guideline fiannce roadmap ESG reporting guideline Source: World Bank team illustration 43. Despite these milestones, the capital flows provided through eight commercial banks.¹8 towards climate-related projects are low. This leaves very little room for development of They have tripled from a very low base and a commercial climate finance market, pointing represented 2.9 percent¹7 of bank portfolios to the need to reform the subsidy schemes to in 2023 (Figure 14). Green lending from banks crowd-in the private sector. currently goes towards climate mitigation for households for efficiency, pollution prevention, 44. Limited understanding of the financial and and water use. SMEs make up less than 1 economic returns on investments aiming to percent of the borrowers. The availability of reduce climate risks is a major issue. There adaptation finance is very limited, although is still a lot of skepticism around the climate critically needed for long-term investments agenda in Mongolia, even as the consequences across several value chains, such as meat, of climate change are felt across the country. dairy, cashmere, post-harvest storages, The lack of adaptation policy and the need for waste management, eco-tourism, bioenergy preparedness for climate change and further and transport. The current government integration of ESG standards remain to be subsidies programs for fossil fuel, housing, promoted across SMEs, agriculture/ livestock and livestock inadvertently slow down the value chain players, and the line Ministries. flows of capital to green investments, as they create a disincentive to shift to climate-led solutions. According to the IFC’s agriculture finance report, between 2009 and 2020, 1.1 million citizens and enterprises benefited from monetary supports and incentives associated with wool, leather, and wheat. Subsidized loans at 3 percent interest rates for working capital and 5 percent for investments for crop production, food processing and packaging, for a total of MNT 1.7 trillion are expected to be 17 Mongolian Sustainable Finance Association report 18 This refers to the "President’s Food Supply and Safety Program." Approved by Parliament in June 2022, this 5-year initiative aims to meet domestic demand for 19 major food products. In the future, it seeks to position the country as a food exporter and establish a region free of animal diseases. 5. Fostering market development 41 Building the foundations for financial sector development in Mongolia Figure 14. Bank green lending composition by products (%) 3.2 100.0% 5.0% 15.6 11.4 90.0% 21.5 21.8 22.2 23.2 25.8 22.7 26.7 30.2 26.1 24.9 28.1 80.0% 4.0% 70.0% 3.3 60.0% 3.0% 50.0% 2.5 40.0% 2.0% 30.0% 20.0% 1.0 1.0% 10.0% 0.0% 0.0% 2020Q1 2020Q2 2020Q3 2020Q4 2021Q1 2021Q2 2021Q3 2021Q4 2022Q1 2022Q2 2022Q3 2022Q4 2023Q1 2023Q4 Renewable energy Energy efficiency Pollution prevention/reduction Sustainable land use, forest and eco tourism Sustainable agriculture Low-pollution energy Green building Sustainable waste/water use Low carbon transport Share in the total banks’ portfolio 45. The supply of green finance from the banking it should provide an additional incentive to and microfinance sector is expected to grow, encourage diversification of loans to other but only if the constraints are tackled (Table sectors. There is a big expectation that the 4). There has been no systematic assessment commitment made by the six banks, to allocate of the climate risks faced by the financial 35 percent of the capital raised from their sector in Mongolia, but it is estimated that IPOs to green loans, will help grow the green the effects of extreme climate events could finance market. However, if the constraints severely affect banks and investors, given below are not addressed, this commitment is their large exposure on mining, housing, and unlikely to be realized. households. This may raise concerns, but table 4. Barriers to increasing the supply of sustainable finance from banks Barrier Category of Constraints High costs of The high costs of funding (between 10 to 15 percent) may challenge the ability of the financial funding for banks sector to scale up their portfolios. and limited High costs to conduct green screening processes and certification, especially for small-scale profitability of projects, make green lending a less profitable business for financial institutions. In addition, the climate-related loans lack of climate-related data makes screening and underwriting more difficult. Lack of options to transfer or mitigate risks of lending to or investing in green projects reduces Lack of risk the appetite of the lenders and investors for such projects or programs. This is a key challenge mitigation for agriculture, livestock, SMEs, and infrastructure projects, which have significant perceived and instruments real risks. While the ESG framework is well advanced in Mongolia, with ESG risk guidelines and investments principles well integrated in the banking and capital markets regulatory framework, the ESG MRV frameworks for monitoring, reporting and verification (MRV) systems are missing. considerations Diverse public opinions, skepticism about climate finance, and lack of effective communication about the urgency and benefits of climate action to build and maintain public support are all constraints. Lack of clarity on adaptation finance in some key sectors is a constraint. Institutional capacity and readiness Lack of alignment between existing subsidies and ambition to increase private capital for climate investments is also a constraint. 42 5. Fostering market development Building the foundations for financial sector development in Mongolia 46. Stronger reliance on capital markets through better alignment with the Government’s sovereign green bonds market issuance will climate agenda, integration of clear climate be needed to support the increase of capital targets, and capitalization so that they act flows in climate mitigation and adaptation as wholesalers and extend long term loans/ projects in Mongolia. The green bonds line of credit to financial intermediaries for on- market is still nascent even though Mongolia lending for climate purposes. has an advanced green bond framework in place. The launch of a corporate green bond (3) Support the creation of monitoring, by Khan Bank was expected to send a signal, reporting and verification systems to avoid but it did not create the expected momentum double counting and promote strong climate for green bond market development. As quality management systems. This will mentioned elsewhere in this report, the lack require (i) either creating a dedicated agency of sovereign issuance providing a benchmark or encouraging the entry of private MRV yield curve is one of the main reasons. The agencies in Mongolia; (ii) building capacities development of the financial sector would for emission reduction tracking; (iii) building involve the appropriate sequencing, and a digital registry of green projects that could setting priorities and coordinating numerous be made available to financial institutions; reforms, to allow adequate development of and (iii) leveraging technology such as smart institutional capacity and associated market sensors, satellites and drones, and artificial infrastructure. Efforts aimed at identifying intelligence for MRV. This is to be done in the pipeline of green projects, and developing addition to continuing efforts to integrate ESG an investor base (as mentioned above) will standards and considerations. need to be ordered around the development (4) Explore options to mobilize funding for of the government securities market providing climate mitigation actions, such as through the benchmark for pricing corporate bonds, voluntary carbon markets. Voluntary carbon thereby bolstering the opportunities to markets offer promising opportunities to better rely on capital markets to support the mobilize funding for climate mitigation country’s climate transition and preparedness actions. The global carbon market is estimated for climate change. at US$3.3 trillion, and while the market has 47. To summarize, for the financial sector to play been growing fast, it remains out of reach a bigger role in advancing access to climate to many developing countries. In the case of finance, five main factors will need to be put Mongolia, given the potential for reduction of in place by the Mongolian authorities: emissions from livestock, and manufacturing value chains, the opportunities of mobilizing (1) Integrate climate/green related resources from carbon markets are worth objectives and criteria into the remaining exploring. government subsidy programs after review and restructuring, especially for the most (5) Leverage capital markets to channel vulnerable groups that cannot be served by domestic and international institutional commercial financial solutions, including investors’ resources by issuing sovereign smallholder farmers, herders, and housing¹9. green or sustainability-linked bonds. And And encourage issuance of corporate green and (2) Open a climate finance guarantee window sustainability-linked bonds. In addition to the as part of the new guarantee scheme and recommendations for sovereign securities strengthening the green public finance issuance above, other aspects such as the instruments (such as the Mongolian Green development of a pipeline of investable Finance Corporation [MGFC] and the Billion climate adaptation and mitigation projects Tree Fund), so that they can be better will be needed. This entails (i) coordination leveraged to lower costs and de-risk finance between the line ministries responsible for for the climate agenda. The strengthening the mapping of environmental/green public of these green public instruments includes and large private projects, and expenditures 19 Another important factor to consider would be to facilitate the availability of relevant green technology and business model options, especially for priority groups such as small farmers, herders, and SMEs. Additionally, nationwide campaigns should be launched to promote their application and importance. 5. Fostering market development 43 Building the foundations for financial sector development in Mongolia in key sectors such as: biomass (use of enabling factor for domestic businesses to livestock waste for energy production), agro- access export markets. industry, low carbon transition of the livestock sector, agro-silvo-forestry, waste and water 49. Lack of collateral remains one of the key management, and others, in accordance with constraints to accessing finance by SMEs. the green taxonomy and country climate The Credit Guarantee Fund of Mongolia (CGFM) objectives; and (ii) encouraging private green was established in 2012 with the objective of project development by generating awareness de-risking lending to SMEs through a public on green principles and ESG considerations. credit guarantee scheme (CGS) (Box 1). These schemes are a widely used policy tool to 48. Establishing an effective credit guarantee. facilitate creditworthy SMEs’ access to finance. It is recommended that the authorities Public CGSs are particularly relevant and establish a new credit guarantee fund effective when there is enough liquidity in the capitalized to carry out a broader mandate, financial system, yet certain market segments providing both loan guarantees as well as (such as SMEs) are excluded due to risk export credit insurance and domestic trade aversion by credit providers. However, CGFM’s credit insurance. An effective and professional impact and outreach has been limited, having partial credit guarantee can play an important issued only 1,194 guarantees for a total value role in relieving constraints on SME lending, of MNT 190.5 billion since its establishment 14 as the guarantee substitutes for collateral years ago. Banking representatives indicated required by banks. Similarly, effective and that guarantees are not easily accessible and accessible domestic credit insurance can play that the guarantee fund has not been reliable an important role in facilitating domestic trade in meeting its payment obligations when finance, while export credit insurance is a key guarantees fall due. Box 1. Credit Guarantee Fund of Mongolia (CGFM) CGFM was established in 2012 under the Law on the Credit Guarantee Fund with the objective of providing partial credit guarantees to SMEs on loans from banks and NBFIs. The guarantee fund was established with an initial capital injection of MNT 5 billion (US$1.5 million) with further capital injections of MNT 50.3 billion since establishment, resulting in a total capitalization of MNT 55.3 billion. The Board of Directors of CGFM is dominated by government officials and has limited commercial orientation. In the 14 years since its establishment, CGFM has only issued 1,194 guarantees with a total value of MNT 190.5 billion. During the period of 2016 to 2023, the average value of guarantees provided has varied between MNT 169 million (US$125,000) and MNT 420 million (US$312,000), with a trend towards larger guarantees and away from the intended SME target market. According to data provided by CGFM, the default rates on guaranteed loans have been high, varying between 9 and 18 percent in the period since 2018. The credit guarantee fund is not financially sustainable and is dependent upon ongoing external subsidies. CGFM fees and commissions constitute between 0.7 and 1.2 percent of the guaranteed portfolio, well below the level of credit risk on guarantees issued, while the income from guarantees issued covered only 16 percent of total cost of operations in 2022 (and 33 percent in 2021)²0. The shortfall is funded from the interest received on investments of funds received from the Asian Development Bank (ADB), intended to fund the guarantee portfolio²¹. Without this investment income, CGFM would be unable to fund its operating costs and would be dependent on ongoing transfers from the Government. 50. The newly established credit guarantee fund credit information, and their inability to should aim to mitigate risks associated with produce financial statements. These factors lending to the SME sector on a financially limit access to finance and drive high interest sustainable basis. This would support rates on lending to SMEs. An effective credit lending to collateral constrained SMEs, such guarantee fund that conforms to international as herders, agribusinesses, and the range best practices and operates consistent with of small businesses with limited access to the Principles for Public Credit Guarantee finance due to collateral limitations, weak Schemes (as laid out in Annex 7), can play an 20 World Bank study team estimates based on CGFM financial reports and discussions with CGFM in September 2023. 21 The ADB provided US$60 million in funding for loan guarantees at prescribed guarantee terms and guarantee premium. The investment income from this funding currently subsidizes operational income. This subsidy will cease at the end of the ADB contract term (unless an extension is granted). 44 5. Fostering market development Building the foundations for financial sector development in Mongolia important role in inducing banks and NBFIs orientation, and appropriate risk management to expand coverage in underserved market systems and underwriting standards²². segments, while also improving the finance conditions for SME clients (e.g., lower interest 51. Insurance instruments, such as export rates, larger loan sizes, and less burdensome credit insurance and domestic trade credit collateral requirements). Any capitalization insurance, also play an important role in of the credit guarantee fund should be made easing access to credit. The beneficial impact contingent upon successful restructuring of export credit insurance and domestic trade of corporate governance arrangements credit insurance are broader as they apply to (limiting political interference in operational not only banks and their clients, but all parties decisions), strong commitment toward market to commercial trading relationships (Box 2). Box 2. Trade credit insurance Trade credit insurance enables suppliers to increase their overall sales turnover, reduce losses related to credit risk, and improve the profitability of their business. Trade credit insurance helps to facilitate international trade flows and contributes to global economic growth, allowing transactions to occur that would otherwise have been too risky. It also enhances economic stability by sharing the risks of trade losses with trade credit insurers, which have greater capacity to diversify and absorb such risks. There is a long history of governments taking the lead in establishing domestic and export credit insurance facilities. The purpose of these interventions is a mix between promotion of domestic or international trade, industrial development, and creation of employment. Examples are found across most of Europe, Latin America and Asia – from Switzerland in 1906 and the UK (various guarantee schemes established between 1919 and 1933) to the establishment of guarantee schemes across Europe and Scandinavia to support economic recovery after the First and Second World Wars. From the 1960s up to 1990, an additional 33 countries established credit guarantee mechanisms. 52. It is recommended to explore the feasibility Success will be critically dependent on (a) a of a national initiative to provide both loan sound governance structure and professional guarantees as well as export and domestic management team, mandated to operate trade credit insurance through a guarantee independently from government interference; institution with a broad mandate. There is and (b) adequate capitalization to enable the complementarity in virtually every aspect of institution to create a commercially viable and these different types of insurance businesses, sustainable insurance portfolio. Mongolian encompassing (i) credit risk assessment Re has piloted the establishment of an and credit risk management expertise; (ii) export credit insurance facility for non-mining expertise in different aspects of insurance exports, through the Export Development and re-insurance; (iii) management and risk Project. Unfortunately, several obstacles information systems; and (iv) sales and were encountered which made it hard to contract origination. Given the limited size achieve viability, including the limited size of of the market for these different kinds of the targeted market. This could be addressed credit insurance in Mongolia, an institution through an institution with a broad mandate that works across these different areas as discussed here. would offer better prospects of building a viable business than separate institutions working only on any one single area. There is also substantial opportunity in all these areas for collaborative relationships with both insurers and banks, which can serve to strengthen and deepen the insurance sector. 22 This may also require investment into programs to support or encourage the development of financial products and services that meet the specific financing needs and business characteristics of SMEs and align with their ability to provide necessary collateral. Such innovative lending and financial products should become mainstream financing tools for SMEs. This approach would significantly contribute to SMEs’ access to finance in a commercially sustainable manner. 5. Fostering market development 45 STRENGTHENING CREDIT 06 MARKET INFRASTRUCTURE Building the foundations for financial sector development in Mongolia 53. Addressing weaknesses in credit market categories of clients. infrastructure, both related to contract enforcement and credit information sharing, 55. The authorities urgently need to reform is a prerequisite for sustainable expansion Mongolia’s credit information infrastructure, in business finance. These weaknesses are which fails to meet the evolving needs of significant factors driving high levels of non- either the BOM or private sector credit performing loans and high cost of credit. providers. The authorities intend to introduce Weaknesses in the infrastructure for credit private credit bureaus to serve the credit information sharing have been evident for information needs of private sector institutions some time and were highlighted already in the and to restructure the BOM Credit Register 2012 FSAP Technical Note covering financial to serve the needs of bank supervision sector development issues developed by and financial market monitoring. The Law World Bank and IMF staff. The slow pace on Credit Information is being redrafted to and ineffective reforms fail to encourage create the basis for a regulatory framework SME finance, as financial intermediaries for both the BOM Credit Register as well as remain unconvinced that the authorities will for private credit information sharing. Two proceed with the reforms. It is possible to private credit bureaus were licensed in 2022, address such weaknesses in the short term, but the transition to private credit information resulting in significant expansion of outreach sharing has been slow and haphazard. The by financial intermediaries to SMEs and other role of the private bureaus is currently limited underserved market segments, as well as to distribution of credit reports retrieved significant improvement in credit selection from the BOM Credit Register, and they are and in credit risk management, which would not permitted to receive data directly from result in a reduction in non-performing loans. credit providers or to establish their own independent databases. Thus, it is urgent that 54. As sanctioned by the 2011 Law on Credit the new law be finalized so that the powers Information, the BOM has been operating a and functions of the private credit bureaus credit register since 2013, with participants and the relationship between the BOM Credit including banks, NBFIs and other selected Register and the private credit bureaus is institutions. As of December 2022, the clarified. A structure that enables international BOM Credit Register contained information best practices in private credit information on approximately 3 million individual loans sharing, including direct reporting by private (representing outstanding loan value of sector financial institutions of expanded credit MNT 17.9 trillion) and 30,000 businesses data to private bureaus, based on the principle (representing outstanding loan value of of reciprocity²³, will best serve the credit approximately MNT 12.8 trillion, Table 5) information needs of the Mongolian financial and was used by 12 banks and 549 NBFIs. services sector. The BOM Credit Register Unfortunately, the quality of data is weak and should similarly be restructured to better payment history data is not included in credit support risk-based banking supervision and reports. The BOM Credit Register does not enable improved credit market monitoring. provide any of the analytical services required An illustration of the credit information by modern credit selection and credit risk flows in a restructured credit information management, such as scorecards, portfolio system is provided in Figure 15²4. In phasing risk analysis, or reports to optimize debt implementation of these changes, it will be collection (to name only a few). Furthermore, important to maintain access to the BOM the credibility and reliability of the credit Credit Register until the private credit bureaus register is undermined by the practice of are fully functional. ad hoc removal of credit data for certain 23 Reciprocity in credit information sharing: only institutions that report data have a right to receive data, with an equivalence between the range of data reported and data received. 24 The World Bank task team has had detailed discussions with officials on these requirements during the various missions covered by this study, and the BOM should be able to proceed with implementation. However, this would be a substantial undertaking, as the project will involve several technical steps, such as the design of the technical architecture, development of detailed user requirements, and identification of technical service providers, all before deployment, integra- tion, and commissioning of the new credit register. 6. Strengthening credit market infrastructure 47 Building the foundations for financial sector development in Mongolia Table 5. Data on BOM credit register (million MNT) Statistics on BOM Credit Register Loans on Credit Register - Individuals (2022) Number MNT- mil Commercial banks 1,716,694 15,295,601 Non-Bank Financial Institution 927,022 2,126,865 Credit Cooperatives 15,509 68,081 Other 354,096 425,119 TOTALS 3,013,321 17,915,666 Loans on Credit Register - Business (2022) Number MNT- mil Commercial banks 24,137 10,534,840 Non-Bank Financial Institution 1,119 185,779 Credit Cooperatives 83 30,857 Other 5,047 2,088,760 TOTALS 30,386 12,840,237 Figure 15. Structure of credit information flows Core Retail & Large exposure directly reported by Bank supervision & market Banks & Data BoM credit monitoring for financial banks & NBF1s NBFls Large exposure & related parties register stability & monetary policy Core retail data (aggregated) aggregated information per credit provider Banks, Expanded Date NBFls & Core ID, address & employment other data commercial Repayment history Banks NBFls & entities Collateral directly reported by banks & Commercial Sector Private Repayment history NBF1s to private bureaus credit Credit reports, scores, Property, car & other rental & bureaus portfolio reports, early lease data warning indicators & other Mobile & service payrnents products Public utility data Livestock data Principles: Submission of expanded credit data directly from institutions to private bureaus, based on standard data definitions. Reciprocity: only institutions that report data has a right to receive data, with an equivalence between data reported and data received Avoid data exchange through Credit Register as intermediary. This increases operational complexity and risk and limits flexibility for expansion and technological development. Aggregated data reported from private bureaus to Credit Register for institutional and credit market monitoring. 56. Beyond improving information on borrowers the prudential rules applied to credit²5 risk and exposures, more risk-based capital and are not sufficiently risk-sensitive, as they do prudential requirements are likely to reduce not differentiate adequately between good the cost of credit and therefore facilitate and bad risks²6. There are linkages between access to finance for businesses. Currently, the prudential treatment and the cost of, and 25 See Decree 138 of 2019. 26 This inappropriate calibration is also found for other risks, such as operational risk where the current regulatory framework paradoxically results in exempting loss-making banks from capital charges even though the latter are likely to be more exposed to operational losses due to their more limited capacity to invest in risk management and resources. 48 6. Strengthening credit market infrastructure Building the foundations for financial sector development in Mongolia access to, credit. If the BOM were granted more purpose of delaying contract enforcement flexibility in setting prudential rules that better and collateral recovery²7. A law dealing with align with the actual borrowers’ probability of insolvency proceedings and insolvency default and the potential losses, the cost of resolution has been drafted, but enactment credit would be better aligned to the level of has been pending for several years. Legislative risk. This would result in better distribution, reform of the civil code, the code on court a reduction in NPLs, and improved quality of procedures, and the code on enforcement of earnings for banks, which would boost credit judicial decisions, is also urgently required. to the economy. These weaknesses appear to be recognized by all stakeholders, but the process of reform 57. In addition to weaknesses in credit is taking an extraordinary length of time information, NPL resolution is undermined and is having a significant impact, elevating by serious weaknesses and inefficiencies credit losses for bank and non-bank credit in the legal and judicial framework that providers and creating disincentives standing undermine contract enforcement and in the way of collateral-based lending to the increase credit losses. Weaknesses in business sector. These factors contribute to contract enforcement have been identified high interest rates (required to compensate by numerous studies (Box 3). Existing judicial for elevated credit losses) and can undermine procedures provide excessive latitude for bank solvency and stability. appeals and obstruction by debtors with the Box 3. Multiple studies and expert assessments confirm weaknesses in contract enforcement The IMF’s 2011 Country Report for Mongolia notes the following challenges: Mongolia’s business climate ranks well below mineral resource-rich peer economies. Notable problems exist in electricity supply (infrastructure gaps); cross-border trading arrangements (widespread corruption); resolving insolvency (regulatory weaknesses and ineffective contract enforcement reflecting long and unpredictable judicial procedures and limited capacity for commercial dispute resolution); and initiating and operating businesses (weak governance and transparency) (IMF, 2011). The following are specific areas of weakness in contract enforcement identified by the World Bank’s Mongolia Business Environment and Competitiveness Assessment Report (2022): • Resolving a simple commercial dispute through a first instance court takes more than a year and costs roughly one-fifth of the claim value. • The enforcement of court judgments is a lengthy process that takes as much time as the trial itself. • The Law on the Enforcement of Court Decisions (2017) slows the seizure of collateral by creditors, particularly banks, when the economy is in financial distress. • The quality of judicial processes is weak and not consistent with international best practices. • The Enforcement Law (2017) is outdated and is not adapted to international best practices. • Training of judges and court personnel, particularly on commercial matters, needs to be improved. • The codes of court procedures must be improved, particularly regarding collateral repossession. The rules for Alternative Dispute Resolution (ADR) should be improved to provide incentives for conciliation in commercial cases²8. The assessment of contract enforcement, as per the World Bank’s Doing Business report, provides a rating of 61.4 percent for contract enforcement in Mongolia, indicating an average time of 374 days (about one year) for contract enforcement at an average cost of 22.9 percent of the contract value. 27 Some of these problems have been aggravated by a 2017 Law on the Enforcement of Court Decisions, which slows down foreclosure on collateral by credi- tors, and in particular banks, a disincentive for new lending. 28 This report contains detailed information on different areas of weakness with respect to contract enforcement. 6. Strengthening credit market infrastructure 49 Building the foundations for financial sector development in Mongolia 58. Addressing institutional weaknesses, contradictions³¹. both with respect to credit information sharing and contract enforcement, is of 60. The Law on Tangible and Intangible Movable high priority. These weaknesses contribute Property Pledge (2015)³² created the legal to high credit loss levels and high interest framework for a web-based pledge notice rates, undermining credit selection and registry.³³ The establishment of a web-based access to finance for SMEs. These market Pledge Notice Register in 2017 should enable limitations are compounded by regulatory greater acceptance by banks and NBFIs of forbearance and weak supervision²9. moveable assets being offered by SMEs as Obstacles to contract enforcement, combined collateral, including items such as inventory, with weaknesses in regulatory oversight over livestock, equipment, and contractual loan rescheduling and restructuring, could receipts. The Pledge Notice Register appears well facilitate evergreening. Weaknesses in to be generally accepted and widely used³4. prudential requirements that result in delays As a general principle under the Pledge Law, in NPL recognition result in similar outcomes. pledges which are perfected (which includes Weaknesses in assessing collateral valuations, registration of the pledge on the Register) will combined with weak contract enforcement, rank above other pledges which have not been also lead to elevated credit loss levels and perfected in relation to the same property or may be further aggravated by related party asset³5. transactions and connected lending. Given 61. Despite the 2015 enactment of the Law on the inward-looking ownership structure of Tangible and Intangible Movable Property Mongolian banks, strengthening the corporate Pledge and the 2017 establishment of governance framework in banks should be an the Movable Pledge Register, banks still essential element of any strategy to improve prefer to use immovable assets rather credit risk management and promote effective than movable assets. Up to 80 percent use of instruments such as guarantees. of loans are still supported by claims on 59. While the leasing law was enacted in 2006, immovable assets³6, reflecting both remaining development of the leasing sector has been weaknesses in contract enforcement and the disappointing, with leases only constituting foreclosure process on collateral, and limited less than 2 percent of all credit exposures. This competitive pressure and incentives for banks is largely the result of various inconsistencies to modernize traditional lending approaches. and weaknesses in the leasing law, as well as While the establishment of the Movable a lack of understanding in the courts, which Pledge Register is a positive development, undermines the recovery of leasehold assets³0. without an effective foreclosure procedure to Furthermore, leasing companies are currently facilitate recovery for collateral registered on not licensed or regulated, as they are excluded the Pledge Notice Register³7, this measure from the mandate of the FRC. The leasing alone is insufficient and the impact of the law contains numerous inconsistencies and reform will be low.  29 There is clear complementarity between addressing recognized weaknesses in contract enforcement and achieving the objectives of improving the quality of prudential supervision and bank solvency. 30 A similar lack of understanding amongst customs officers also delays and complicates the import of items purchased through financial leases. 31 Weaknesses include: (a) leases may only be used for the purchase of new assets; (b) limitations on the transfer registration for leasehold assets are not enforced; (c) lessees are disqualified if they have any bad debts on overdue loans; (d) the leasing law allows inappropriate “termination” of a leasing contract; and (e) certain definitions are inconsistent (e.g., the definition of a ‘leaseback’). 32 The registry has only two objectives: (i) to publicize creation of a pledge right in a certain person’s movable or intangible property; and (ii) to determine the priority ranking of the pledge right. The register provides filing and enquiry services for all types of movable-asset security interests and similar transactions, such as finance lease, credit sale, sale and buy-back. Furthermore, this pledge registry system is accessible online for verification, amendment, extension, and cancel- lation of the details of the registered collateral. 33 A movable collateral registry allows SMEs to offer moveable assets, such as accounts receivable, inventory, livestock, equipment, and future income, as collateral to financial institutions. 34 Within three months of the launch of the Movable Pledge Register, more than 10,000 pledges were registered, and by 2020, more than 150,000 SMEs loan agreements were supported by the register. As of June 2023, 670,000 movable asset pledge notices have been registered in the register. Based on the latest sta- tistics from the registry office, around 25 percent of the pledged assets are livestock, 18.4 percent are account receivables, and 8.4 percent are vehicles. Women make up 39 percent of the total borrowers (as of June 30, 2023). 35 Lexology, MinterEllison, Mongolia, May 16, 2017. 36 Based on statistics reported by a leading bank in its annual report. 37 This is at least partly due to weaknesses in the legislation related to enforcement of contracts and requires specific procedures to simplify foreclosure on assets registered on the Movable Pledge Register. 50 6. Strengthening credit market infrastructure Building the foundations for financial sector development in Mongolia ANNEX Annex 1. Implementation status of 2012 FSAP development module policy recommendations Implementation FSAP policy recommendations of June 2012 status as of May 2024 I - Legal, regulatory, and supervisory framework for financial institutions and instruments Competition • Consider encouraging foreign bank entry into the market to bring longer-term funding Not implemented sources, increase competition, and thus improve borrowers’ financing terms. Leasing and factoring • Revise the leasing law and consider preferential tax treatment for leasing transactions. There should be an awareness program on the benefits of leasing as a financial instrument. Not implemented • Review legal framework for contracts assigning receivables with a view to the development of factoring. Technical Assistance should be provided to SMEs and financial institutions staff on factoring. Regulatory and supervisory framework for NBFIs and savings and credit cooperatives (SCCs) • Conduct a detailed assessment of the FRC’s functions and responsibilities, including: (i) realignment of its organization; (ii) assessment of staffing needs; (iii) assessment of training needs; and (iv) improvement of its information technology systems, databases, interconnectivity, and software tools needed to effectively perform its functions. Partially implemented • Improve the quality of regulation and supervision and ensure that it is proportional to the risks posed by various types of NBFIs and SCCs. • Undertake an assessment of the regulatory framework for NBFIs to ensure that it is conducive to the further growth of the sector. Consumer protection and financial literacy • Clearly define the institutional framework for financial consumer protection in Mongolia. • Improve the legal and regulatory framework for financial consumer protection in order to: (i) Partially protect against unfair deceptive practices; (ii) improve transparency through disclosure and implemented plain language requirements for products and pricing, in a way that allows consumers to easily compare offers of financial products; and (iii) establish an efficient and fair mechanism for resolving customer complaints and disputes. II - Financial infrastructure Secured transactions, creditor rights, and insolvency regime • Improve the legal and regulatory framework for secured transactions. • Establish a modern moveable collateral registry. • Provide training and awareness-building to stakeholders on compliance with the new legal Partially and regulatory framework, and on the use of the registry. implemented • Amend the insolvency legislation to make it consistent with international standards. • Clarify and extend the scope of the insolvency legislation to cover non-corporate SMEs. • Strengthen court capacity to handle commercial matters and consider the creation of commercial courts. 6. Strengthening credit market infrastructure 51 Building the foundations for financial sector development in Mongolia Credit information system • Issue license and regulations to enable operations of private credit information bureau. • The BOM’s supervisory process for the private credit information bureau needs be further developed. Partially implemented • The legal and regulatory framework needs be further developed to protect the rights of data subjects to correct information, and to establish a dispute resolution system. • A training program for clients is needed to improve understanding of credit information sharing Electronic payment instruments • Create a national platform to improve interconnectivity and service delivery, reduce the cost Implemented of mainlining and using mobile banking services, and improve customer security. III - Government program for SMEs • Develop a medium-term strategy for SME development, including SME finance. • Consider less costly, market-based mechanisms, that may involve risk-sharing with financial institutions, and which promote efficient credit allocation. • Establish a regulatory framework that ensures that the Credit Guarantee Fund is sound and Partially offers additionality, and that it has adequate institutional capacity. implemented • Provide trainings to SMEs on technology improvement, basic organizational and management skills, financial reporting, and education on financial products via the Banking Association, the business association, or non-governmental organizations (NGOs). Donors can support trainings. Annex 2. Demand-side Study on Mongolia's Private Sector and Green Competitiveness A World Bank study team delivered a report on Boosting Mongolia’s Private Sector and Green Competitiveness in June 2024. The report provides new firm-level data analysis of the micro-foundations of growth and identifies priority reform areas to unleash the potential of the private sector for productivity growth and the green transition. The analysis identifies drivers for increasing private sector contribution to productivity growth and policy constraints to attract investment. Combining firm-level data analysis with an extensive literature review and interviews with public and private sector representatives, the study aims to inform policy discussions on pathways for private sector-led, sustainable, and diversified growth. Based on the analysis, three pathways for policy action emerge to address the limited investment, especially in non-mining sectors: (i) improving the business environment for private investment; (ii) boosting the potential of SMEs and startups; and (iii) unlocking private investment opportunities for a green transition, with a focus on the energy and agriculture sectors. Private investment opportunities exist within the energy sector to boost renewable energy deployment and enhance energy efficiency. Beyond wind and solar farms, investments in distributed small-scale renewable systems and micro- grids also present additional prospects. In addition, there is vast potential for private investments in enhancing energy efficiency solutions for businesses, industries, and households. In agribusiness, there are investment opportunities to boost productivity and access broader markets. Private investment avenues exist within value chains and innovative eco-friendly products, including modernized meat processing, intensive cattle breeding, high-quality dairy goods, and sustainable cashmere products. Concerted efforts to create an enabling environment for private investments in Mongolia’s green transition are necessary, including reforming subsidies in energy and agriculture that disincentivize green investments, upgrading infrastructure, improving access to finance and markets, and enhancing policy predictability. Source: World Bank, Boosting Mongolia's Private Sector and Green Competitiveness (2024) 52 6. Strengthening credit market infrastructure Building the foundations for financial sector development in Mongolia Annex 3. Illustration of connected shareholding structure for some Mongolian banks Bank Sister company Sister Company Operating sector Company A1 International Trade and Production Company A2 Car import, Mining equipments Company A3 Construction Company A4 Cashmere Company A5 Food service, production Company A6 Food services Company A7 Food services Company A8 International Trade and Production Company A9 IT, health Company A10 IT, health Bank A Company A11 International Trade and Production Company A12 International Trade and Production Company A13 Car import, Mining equipments Company A14 Travel services Company A15 Travel services Company A16 Hotel, accomodation Company A17 Travel servic es Company A18 Banking and finance Company A19 Banki ng and finance Company A20 International Trade and Production Company A21 Agriculture, farming Company A22 Food service, production Company B1 Banking and finance Company B2 Insurance Company B3 International trade, media, agriculture food Bank B Company B4 Construction, asset management Company B5 Travel, hotel, accomodation Company B6 Construction, railroad, energy Company B7 Mining and energy Company C1 Banking and finance Company C2 Mining Company C3 Banking and finance Bank C Company C4 Investment and management (mining construction) Company C5 Investment and management (mining construction) Company C6 Construction, railroad, energy Company C7 Construction, railroad, energy Company C8 Mining Company D1 Construction material production Company D2 Construction material production Bank D Company D3 Construction material production Company D4 Construction material production Company D5 Mining Company D6 Mining Source: World Bank study team illustration 6. Strengthening credit market infrastructure 53 Building the foundations for financial sector development in Mongolia Annex 4. Subsidy schemes Over the last decade and longer, the GOM has The participating banks were carrying the credit regularly implemented various types of subsidy risk on the loans originated and earned a ‘margin’ schemes in response to external shocks (such on the loans provided (consisting of the below- as the COVID-19 pandemic) or to stimulate credit market interest rate paid by clients). This resulted flows to priority sectors. Unfortunately, this has in an injection of funding into the economy detracted attention from dealing with fundamental (“creation of money”), a net expansion in credit, and weaknesses in credit market infrastructure, with significantly contributed to inflationary pressure. weaknesses in credit information sharing and The COVID-19 Recovery Program (and most of the in contract enforcement being the most critical. later programs) were structured differently. These These weaknesses, in combination with the programs consisted of direct transfers from the impact of the subsidy schemes, feeds directly into relevant government departments to participating elevated credit risk and distorts credit allocation. banks of the aggregated cost of the subsidy on An extraordinarily high percentage of bank credit the interest rate payable by clients, but excluded is subject to subsidies, with between 23 percent any access to BOM funding. These later programs to 40 percent of bank loan portfolios having been therefore had a significant fiscal cost but limited part of subsidized loan programs over the last monetary policy impact. decade, with an average of 30 percent over the period. Subsidized loan programs were a major There are severe reservations on whether component of the Price Stabilization Program these subsidy schemes have been effective in (2012–2016), and again, of the MNT 10 trillion reaching targeted market segments, as is the COVID-19 Recovery Program³8. The SME sector case in the loan program for food and agriculture (including the agricultural sector) and retail production (introduced by MOFALI), given (a) the housing were major beneficiaries of these subsidy significant costs in administering the subsidies schemes, but it seems highly unlikely that the imposed on the BOM and the private banks; (b) level of lending will be sustainable if the subsidies the uncertainty associated with banks being able are reduced or withdrawn. The subsidies have and willing to originate sufficient loans eligible also heavily distorted credit allocation, with for subsidy; (c) the impact of the design of the stakeholders reporting a bias in allocation of subsidy that further reinforces the tendency of subsidies to economic interest groups and often banks to exclude more risky, marginal borrowers; being allocated to large businesses rather than as well as (d) the distortive impact of subsidies SMEs. in diverting loan funding away from other (unsubsidized) businesses, with potentially higher The subsidy schemes that were implemented in growth potential, to subsidized loans. the 2012–2016 period were structured differently than the COVID-19 Recovery Program and later interventions, with significant implications for their impact on banking incentives and credit flows (Table 6). During the Price Stabilization Program (2012–2016), the BOM provided funding to banks at below-market rates for lending to clients at subsidized (below-market) interest rates. 38 For further detail on the cost and impact of the Price Stabilization Program, please refer to KPMG’s report, “Special Review of Quasi-Fiscal Policy Activities” (KPMG, 2018). For further detail on the cost and impact of the COVID-19 relief measures (“10 trillion program”), please refer to the BOM report, “Implementation and Outcome of the 10 trillion Comprehensive Plan for Economic Recovery” (BOM, 2021); and to the BOM presentation titled “Loans to support Food and Agricultural Industry” (dated March 22, 2023). 54 6. Strengthening credit market infrastructure Building the foundations for financial sector development in Mongolia Table 6. Main features of the subsidy schemes Subsidy program during and Subsidy programs Quasi-fiscal activities Newly introduced programs after the pandemic Implementation 2012–2016 2020–2022 2023 and beyond period To safeguard jobs and mitigate To address supply shortages To support domestic the pandemic's economic in certain goods perceived as production capacity, mitigate Main objectives impacts through soft loans contributing to seasonal price climate risk, and support to different segments of the fluctuations through soft loans export-oriented industries economy Economy-wide intervention Multiple sectors (mostly Agriculture, primary producers, Target sectors (mostly SMEs operating in construction and housing) herders, etc. services sectors) Main implementation BOM GOM agencies and BOM GOM agencies agency Subsidized financing through banking sector. (The subsidies consisted of direct transfers Subsidized financing through from the GOM to respective banking sector. (The BOM Main financing banks, to cover the difference funded the subsidized loans Cashmere structure between the market interest through transfers to banks at rates and the subsidized rates. below market interest rates.) The programs used bank funds to allocate the credits to the private sector.) Forward agreements, bonds, Other instruments Long term repo by BOM Credit guarantee by CGF promissory notes, etc. No direct fiscal cost Fiscal cost (contingent liability through Direct fiscal cost Direct fiscal cost BOM losses) Direct injection of funding Re-circulation of the banking Monetary policy into the economy, with a sector excess liquidity, thus Food services implication net expansion in credit, thus limited monetary policy impact inflationary pressure Credit risk Banks, BOM Banks Banks Inflationary effect High Moderate Moderate The size of the BOM subsidy schemes over the even after the implementation of the "10 trillion” period of 2012 to 2022 was equivalent to an COVID-19 Recovery Program and the “Subsidized average of 24 percent of the banking sector's loan program supporting food and agriculture loan portfolio, and increased to 40 percent production”. Table 7 provides an overview of the during the COVID-19 period (refer to Figure 11). level of subsidized lending as a percentage of the Most subsidized loans disbursed under the total loan portfolio over the period since 2011. The Price Stabilization Program had been repaid following summarizes the impact of the primary by the end of 2016. However, the subsidized subsidy schemes implemented from 2012 to Mortgage Loan Program remained active and 2023. continues to be the largest subsidy program, 6. Strengthening credit market infrastructure 55 Building the foundations for financial sector development in Mongolia Table 7. Outstanding amounts of the subsidy schemes, as end of the year (billion MNT) Quasi fiscal activities 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 and subsidy programs Quasi fiscal activities 205 2,473 3,372 3,359 4,342 4,468 4,439 4,278 4,381 4,925 4,881 5,204 Construction Materials 264 212 148 25 2 2 Fuel sub-program 94 173 176 126 Food Storage Capacity Increase 99 132 82 13 Coal sub-program 68 36 0 Meat sub-program 87 62 17 Trade Logistics and Facility 12 16 1 Flour sub-program 24 12 47 Supply of Construction program 535 175 Subsidized Mortgage Program 1,249 2,028 2,591 3,116 3,290 3,321 3,434 3,639 4,296 4,737 5,204 ASEM 60 Cashmere 6 DBM 177 Good program 374 374 374 374 374 374 97 TARP 350 350 815 803 743 470 367 256 47 Subsidy programs during and after COVID 0 0 0 0 173 160 67 60 294 3,293 2,506 1,366 Job support 1,750 1,088 278 Agriculture support 441 416 130 Aviation sector support 58 Long term repo finance 173 160 67 60 294 1,101 982 740 Cashmere support 116 Flour production support 20 Local business support 1 Meat stockpile program 43 Subsidy programs planned and/or started recently 0 0 0 0 0 0 0 0 0 0 0 808 Food supply 808 Total 205 2,473 3,372 3,359 4,516 4,628 4,506 4,337 4,674 8,218 7,387 7,378 Total as share of bank loan outstanding 3% 23% 27% 29% 37% 34% 26% 24% 27% 40% 34% 27% Source: BOM, KPMG and World Bank study team estimation 56 6. Strengthening credit market infrastructure Building the foundations for financial sector development in Mongolia It is crucial to reduce the moral hazard associated subsidies to borrowers, resulting in strong credit with the government subsidy programs and expansion. However, with waning fiscal space, quasi-fiscal activities. After the termination of the continued support of this magnitude is not emergency pandemic measures, the Mongolian sustainable. To enable financial sector deepening, banks showed limited willingness to lend outside the Government will need to focus its attention on the quasi-fiscal support programs offered by the measures that will support diversified economic authorities. Furthermore, excessive government growth, particularly through growth in the SME interventions, especially in the financial sector, sector. This will also make a positive contribution will also introduce moral hazard through factors to employment creation and exports. such as the borrowers’ willingness to service debt obligations, which increases the level of risk When subsidies are well-targeted, properly and instability in all sectors of the economy. It is designed, and implemented to address specific therefore important to take measures to gradually market failures or address specific socio- decrease the level of reliance on the government economic objectives, they can yield favorable subsidies and similar interventions, address outcomes (Table 8). These include creating jobs the institutional weaknesses (such as contract in marginalized areas, ensuring adequate food enforcement and credit information sharing) that or medical supplies during crises, and meeting increase credit risk, and strengthen the regulatory environmental goals. More broadly, subsidies can framework for the financial sector. help align market equilibria with social objectives. Therefore, the Government of Mongolia should The government support through these subsidy revise its objectives to be less distortionary schemes is unsustainable. The Government and more targeted, making subsidies more provided substantial support through funding sustainable, efficient, and effective. provided to the banking sector as well as interest Table 8. Possible distortive effect by objective of the subsidy schemes Possibly distortive Possibly ambiguous Possibly less distortive Sectoral Economic/ regional development R&D/innovation Industry restructuring SMEs and entrepreneurship Public services SOEs Transportation Infrastructure Disaster/climate change readiness/ Fuel/energy provision Clean energy response International trade Financial markets participation Public health/safety FDI Business services Social PPPs Capacity building Employment Regulatory compliance, certification Environmental preservation National traditions/heritage Support for ethnic minorities Support for people with disabilities Gender-related support Cultural enrichment Children/adult education Water conservancy/treatment Source: World Bank, “Unfair Advantage: Distortive Subsidies and Their Effects on Global Trade” 6. Strengthening credit market infrastructure 57 Building the foundations for financial sector development in Mongolia Annex 5. Could carbon markets be leveraged to capitalize more resources for climate finance? Voluntary carbon markets offer promising projects, either through carbon removals or opportunities to mobilize funding for climate emissions reductions. In the case of Mongolia, mitigation actions in Mongolia. The global carbon the carbon credit linked to reduced emissions market is estimated at US$3.3 trillion, and while from dedicated projects in livestock value chains, the market has been growing fast, it remains out waste management, and agro-silvo-pastoralism of reach to many developing countries. In the case could be potentially purchased by potential of Mongolia, given the potential for reduction of international buyers and mining companies. But emissions from livestock and manufacturing value for that to happen, there is a need to support the chains, the opportunities for mobilizing resources development of such projects. The Government from carbon markets are worth exploring. Support is urged to support the creation of a carbon fund for the development of a whole carbon finance that could mobilize funding from donors, and framework can be assessed further, but there is carbon credit purchasers for investments in the a strong case to start with a low-hanging-fruit form of equity and debt in medium and large- program, aimed at improving carbon finance in scale carbon offset projects in Mongolia across the voluntary carbon market for the livestock and various sectors. This could be done as a pilot in derived value chains, for a demonstration effect. some regions of the country, with the potential to Voluntary carbon markets are spaces where be expanded. Other issues around the labeling, entities buy carbon credits to offset some or all MRV process, and carbon pricing issues will have their own carbon emissions. These carbon credits to be tackled alongside this. are issued in relation to climate change mitigation Annex 6. Opportunities to build climate resilience for herders in the livestock sector of Mongolia The Mongolian livestock sector dominates the risk retention and risk transfer to manage the agriculture sector (87 percent of agriculture GDP) cost of coverage and incentivize risk reduction. and is highly vulnerable to dzudz. Agricultural Herders retain small losses (when livestock contribution to GDP has declined significantly, mortality is less than 6 percent) that do not affect from 40 percent at its peak (1995) to 13 percent of the viability of their livelihoods, while large losses GDP (2022), due to economic diversification. The (of 6 percent and above) are transferred to the sector remains important for jobs, as it employs 1 private insurance industry. The impact on herder in 4 people in Mongolia’s workforce and supports welfare and resilience has been significant. Net half the population (3.5 million). As a result of income increased for insured herders, increasing dzudz in 2010, over 50 percent of herders (or by between 4 to 7 percent in two assessed soums. 75,000 herders) lost more than half their livestock. Improved risk management has increased Successive dzudz that occurred between 1999 productivity; the herd values of insured herders and 2002 resulted in the loss of US$200 million were found to be 12-19 percent higher than those from the death of 11 million animals (33 percent of uninsured herders in Jargalant soum. Currently, of the national herd). Consequently, the poverty the private sector manages the operations of rate increased from approximately 30 percent in the scheme with Mongolian Re placing the 2000 to over 40 percent in 2004. reinsurance program on behalf of the pool in the international reinsurance market, while the In 2008, the GOM implemented a program to Government funds the annual mortality survey create an index-based livestock insurance which enables determination of payout. A review market to adequately pool risk and enable of the operations of the scheme would be needed affordable insurance to strengthen the resilience to assess reinsurance and operational gaps to of Mongolia’s herders. This program balanced further strengthen the program. 58 6. Strengthening credit market infrastructure Building the foundations for financial sector development in Mongolia There is a need to consider innovative, cost- line with global best practices, which shows that effective, last-mile distribution channels to insurance is more effective at increasing resilience reach more herders and increase uptake of when packaged with other financial services, insurance. Coverage of index-based livestock including credit to increase productivity or indeed insurance (IBLI) has increased significantly, from contingent credit to manage less serious events. 9 percent of herders in 2006 to about 19 percent Therefore, there is a need to consider innovative, in 2023 (Figure 16), but has failed to reach most cost-effective, last-mile distribution channels to farmers because it is distributed through banks, reach more herders. The GOM could explore the which means that only herders that are financially potential for fintech and insuretech in Mongolia included have access. Despite the significant to expand this credit-linked insurance coverage to distribution challenge, overall, the program is in more herders. Figure 16. Coverage of mortality index livestock insurance in Mongolia, 2006–2023 Ratio to the total herder households Between 8-20% of herders are purchasing insurance every year % Number of insured household herders Reaching national 19% coverage 20% 19% 19% 20 17% 35,703 16% 15% 15% 14% 33,719 32,337 34,709 16 13% 13% 11% 12% 28,527 10% 10% 27,456 0% 9% 24,148 10 19,445 7% 18,738 10,909 15,988 14,331 5 5,628 6,977 10,317 2,422 3,705 4,047 0 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 Payout of US$ 340 k to 1,783 Cumulatively, in 10 insurance cycles over 10 years, a total 93,700 herders purchased index-based insurance, After insurance payouts herders who received a payout paying US$405 m. in premiums, and a total 16,545 Payout of US$ 275 k restocked a larger number of livestock and more rapidly herders received payout of US$160 m. to 2,117 herders than those without Source: World Bank study team illustration Individual-level insurance may not be suitable for backstop the fund in the event of a severe dzud. the most vulnerable herders and a macro-level Alternatively, private contingent credit could also program could be considered for this segment be explored. Ensuring that the lower layers of risk of herders (Figure 17), while deepening financial are covered through reserves (savings) and credit inclusion of this segment. The GOM could assess would enable more cost effective and sustainable the different herder segments to identify the most insurance, given the rising severity and frequency vulnerable herders and assess the potential for of dzudz due to climate change. a macro-level disaster risk financing solution to support these herders. There is a need to undertake   analysis to quantify the climate-related contingent liability of the Government and the funding gap, as well as a Value-for-Money-Analysis to support risk-informed decision making on the most cost- effective combination of financial instruments for the Government to use (optimal risk layering strategy). This could entail a disaster reserve fund to cover moderate dzudz and insurance to 6. Strengthening credit market infrastructure 59 Building the foundations for financial sector development in Mongolia Figure 17. Herder segments and range of financial services based on their risk profiles Financial instruments Target Segmentation Large Farm units (5Ha; 4% of HHS) Access to credit High levels input use Commercial Produce for sale Multi Peril farmers Crop Insurance Medium and smallholder farmers (MPCI) Named Peril (1 - 50%; 38% of HHS) Crop Credit Insurance (long-term Some assets Index (NPCI) finance and Semi=Commercial Some access to credit insurance guarantees) farmers Part consumption / part sale Very few assets (<1Ha; 58% of HHS) Saving and Subsistence farming payments Small Subsistance Very vulnerable to climatic shocks famers Micro credit Social Safety-Net Programs: Government purchases Very few assets; no land insurance on behalf of pre Paid labor identified producers Landless Very vulnerable to climatic Shocks households Source: World Bank team illustration Further, the Mongolia IBLI product is designed a dzud index or pasture index to trigger payout for asset replacement (mortality index before a disaster, so that herders keep their core insurance), which is important but tends to be breeding stock alive. This approach can enable more costly. The GOM could consider developing more affordable coverage, while reducing overall more inclusive index-based financial products mortality, which would more strongly de-risk aimed at asset protection. This could include lending to the livestock sector.   60 Building the foundations for financial sector development in Mongolia Annex 6. Principles for Public Credit Guarantee Schemes (CGSs) for SMEs Credit markets for SMEs are characterized by Operational framework market failures and imperfections. Public credit guarantee schemes (CGSs) are a common form 9. Clearly define eligibility and qualification criteria of government intervention to unlock finance for for SMEs, lenders, and credit instruments. SMEs. 10. Ensure the guarantee delivery approach A credit guarantee scheme provides third-party balances outreach, additionality, and financial credit risk mitigation to lenders through the sustainability. absorption of a portion of the lender’s losses 11. Issue partial guarantees that comply with on the loans made to SMEs in case of default, prudential regulation and provide capital relief typically in return for a fee. to lenders. In 2015, the World Bank launched a tool to help 12. Set a transparent and consistent risk-based governments implement public credit guarantee pricing policy. schemes. The tool has 16 principles covering four key areas that are critical for the success of CGSs, 13. Design an efficient, clearly documented, and as follows: transparent claim management process. Legal and regulatory framework Monitoring and evaluation 1. Establish the CGS as an independent legal 14. Set rigorous financial reporting requirements entity. and externally audit financial statements. 2. Provide adequate funding and keep sources 15. Publicly disclose non-financial information transparent. periodically. 3. Promote mixed ownership and treat minority 16. Systematically evaluate the CGS’ performance shareholders fairly. and publicly disclose the findings. 4. Supervise the CGS independently and effectively. Corporate governance and risk management 5. Clearly define the CGS mandate. 6. Set a sound corporate governance structure with an independent board of directors. 7. Design a sound internal control framework to safeguard the operational integrity. 8. Adopt an effective and comprehensive enterprise risk management framework. 61